Businesses live and die based on their working capital.
Working capital is a measure of operational liquidity. If a business is otherwise financially strong, but does not have enough working capital, it may not be able to pay its obligations. Additionally, it may not be able to invest in new projects and campaigns that it needs to sustain or grow its business.
Working Capital Formula and Definition
Working Capital = Current Assets – Current Liabilities
You may be struck by the similarity of the working capital formula with the Current Ratio. It is true that they both measure the operational liquidity of a business. However, as you will recall, the current ratio is more concerned about the relative sizes of the current assets and current liabilities. Working Capital on the other hand takes a look at the net difference between the current asset and current liability.
After all, if you need a million dollars to build a new factory, the ratio of current assets and current liabilities doesn’t help. You need to know how much of the discretionary dollars are available in the short term to invest.
Working capital is also called the net working capital.
Change in Net Working Capital
Working capital goes up if
- Current assets increase – this can happen when an asset is sold and cash received. It can also happen when new capital is raised through stock or long term bond issue
- Current liabilities decrease – this can happen when the company aggressively pays off the account payables. Please note that this decreases cash, so the net effect may be a wash, unless the reduction is due to additional financing or other similar exercise
Working capital decreases if
- Current assets decrease – this can happen if cash is used to fund new long term projects. Impairment of inventory is another cause of a decrease in working capital. Using the case to pay dividends to the shareholders also reduces working capital
- Current liabilities increase – this can happen if the accounts payables increase or a large amount of long term debt becomes current
Either way, changes in working capital need to be managed carefully as they may indicate a deeper issue in the operational efficiency of the company. A declining working capital reduces growth opportunities and therefore is a cause of concern.
Negative Working Capital
Many times we come accross a company that has a negative working capital. This is the same as a current ration < 1. When this happens, the company may have trouble paying its creditors and suppliers in the short term. This can lead to financial difficulties or even bankruptcy. However, this situation can and does arise temporarily. If the company is otherwise financially strong, it can remedy this situation by either raising new capital, or by converting an existing long term asset to cash (for example, selling of some property).
Working Capital Ratio
Working capital ratio is the ratio of the current assets with the current liabilities.
Working Capital Ratio = Current Assets / Current Liabilities
As you can see, the working capital ratio is the same as current ratio.
Key Takeaway
Working capital funds a business’ growth. As a result, companies need to manage their working capital carefully. A low or declining working capital is cause for concern.