MEANING OF WORKING CAPITAL
Working capital, also known as net working capital (NWC), is the difference between a company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts. It’s a commonly used measurement to gauge the short-term health of an organization.
KEY POINTS ON WORKING CAPITAL
- Working capital, also called net working capital, represents the difference between a company’s current assets and current liabilities.
- Working capital is a measure of a company’s liquidity and short-term financial health.
- A company has negative working if its ratio of current assets to liabilities is less than one (or if it has more current liabilities than current assets).
- Positive working capital indicates that a company can fund its current operations and invest in future activities and growth.
- High working capital isn’t always a good thing. It might indicate that the business has too much inventory, not investing its excess cash, or not capitalizing on low-expense debt opportunities.
OVERVIEW OF WORKING CAPITAL
Working capital estimates are derived from the array of assets and liabilities on a corporate balance sheet. By only looking at immediate debts and offsetting them with the most liquid of assets, a company can better understand what sort of liquidity it has in the near future.
WORKING CAPITAL FORMULA
- To calculate working capital, subtract a company’s current assets from its current liabilities.
- Both figures can found in the publicly disclosed financial statements for public companies, though this information may not be readily available for private companies.
Working Capital = Current Assets – Current Liabilities
When a working capital calculation is positive, this means the company’s current assets are greater than its current liabilities. The company has more than enough resources to cover its short-term debt, and there is residual cash should all current assets be liquidated to pay this debt
When a working capital calculation is negative, this means the company’s current assets are not enough to pay for all of its current liabilities. The company has more short-term debt than it has short-term resources. Negative working capital is an indicator of poor short-term health, low liquidity, and potential problems paying its debt obligations as they become due.
COMPONENTS OF WORKING CAPITAL
- All components of working capital can be found a company’s balance sheet, though a company may not have use for all elements of working capital discussed below. For example, a service company that does not carry inventory will simply not factor inventory into its working capital calculation.
- Current assets listed include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt that’s due within one year.
CURRENT ASSET
Current assets are economic benefits that the company expects to receive within the next 12 months. The company has a claim or right to receive the financial benefit, and calculating working capital poses the hypothetical situation of the company liquidating all items below into cash.
- Cash and cash equivalents: All of the money the company has on hand. This includes foreign currency and certain types of investments such as money market accounts with very low risk and very low investment term periods.
- Inventory: All of the unsold goods being stored. This includes raw materials purchased to manufacture, partially assembled inventory that is in process, and finished goods that have not yet been sold.
- Accounts Receivable: All of the claims to cash for inventory items sold on credit. This should be included net of any allowance for doubtful payments.
- Notes Receivable: All of the claims to cash for other agreements, often agreed to through a physically signed agreement.
- Prepaid Expenses: All of the value for expenses paid in advance. Though it may be difficult to liquidate these in the event of needing cash, they still carry short-term value and are included.
- Others: Any other short-term asset. An example is some companies may recognize a short-term deferred tax asset that reduces a future liability.
CURRENT LIABILITIES
Current liabilities are simply all debts a company owes or will owe within the next twelve months. The overarching goal of working capital is to understand whether a company will be able to cover all of these debts with the short-term assets it already has on hand.
- Accounts Payable: All unpaid invoices to vendors for supplies, raw materials, utilities, property taxes, rent, or any other operating expense owed to an outside third party. Credit terms on invoices are often net 30 days, so essentially all invoices are captured here.
- Wages Payable: All unpaid accrued salary and wages for staff members. Depending on the timing of the company’s payroll, this may only accrue up to one month’s worth of wages (if the company only issues one paycheck per month). Otherwise, these liabilities are very short-term in nature.
- Current Portion of Long-Term Debt: All short-term payments related to long-term debt. Imagine a company finances its warehouse and owes monthly debt payments on the 10-year debt. The next 12 months of payments are considered short-term debt, while the remaining 9 years of payments are long-term debt. Only the 12 months is included when calculating working capital.
- Accrued Tax Payable: All obligations to government bodies. These may be accruals for tax obligations for filings not due for months. However, these accruals are usually always short-term (due within the next 12 months) in nature.
- Dividend Payable: All authorized payments to shareholders that have authorized. A company may decide to decline future dividend payments but must fulfill obligations on already authorized dividends.
- Unearned Revenue: All capital received in advance of having completed work. Should the company fail to complete the job, they may be forced to return capital back to the client.
