Working Capital

This chapter presents an overview of working capital: how a company manages its current assets and current liabilities. Working capital decisions are the day-to-day decisions all companies must make to keep their operations running. While they may not seem as critical as stock issues and capital budgeting, the reality is that poor short-term management is a leading reason why businesses fail. Understanding these concepts is essential for everyone in an organization.

Calculating Working Capital

Working Capital = current assets – current liabilities.

Learning Objectives

  • Calculate a company's working capital

Key Takeaways

Key Points

  • WC is current assets minus current liabilities. Companies want positive WC.
  • WC is an signal of whether or not the company has enough assets to turn into cash to pay upcoming expenses or debts.
  • WC is a measurement of liquidity and is not a guarantee that a company can pay for its liabilities.

Key Terms

  • liquidity: Availability of cash over short term: ability to service short-term debt.
  • current liabilities: All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.
  • Current Asset: An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.

Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

Working capital can be found through the following formula:

WC=CA-CL (Working Capital = current assets – current liabilities)

Current assets (CA) is an accounting term that refers to assets that can easily be turned into cash. For example, cash is a current asset, but so are most accounts receivable.

Current liabilities (CL) is an accounting term similar to CA: CL is the amount of liabilities that are expected to be settled in cash within a year (or the operating cycle of the company).

The difference between the two (WC) is a measurement of liquidity. It signals whether or not the company has enough assets to turn into cash to pay off upcoming liabilities. It is not a perfect signal, however.

Since most expenses and debt must be paid in cash, having positive WC shows that the company has the ability to pay off expenses and debt that will arise or come due in the short-term.

Buying Food: Most purchases, including food, must be made with a specific asset–cash. Not all current assets can be used to pay off expenses of debts.

WC, though, does not guarantee that a company can pay off all short-term expenses or liabilities. Simply having positive WC does not mean necessarily that a company will be able to pay off all expenses. Suppose that a company has current assets of $100: $20 of cash and $80 of accounts receivable. They also have $50 of current liabilities. That means that they have WC of +$50. One of their accounts payable comes due tomorrow, so the company owes $40. They have $20 of cash on hand, but can't get the other $20 by tomorrow because they can't collect $20 of accounts receivable by tomorrow. The company cannot pay a short-term expense, even though a positive WC says that the company should be able to pay off most expenses and loans in the short-term.

WC is not a guarantee that the company will have enough cash for each expense, merely that they have operating liquidity.

Source: Boundless,
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