Liquidity plays a crucial role in a company’s success. It refers to how easily a company can convert its assets into cash. There are several factors that contribute to liquidity. While they may include external influences, these factors are generally internal.
One term often associated with a company’s liquidity is working capital. Therefore, it is crucial to look at what working capital is and how to calculate it.
What is Working Capital?
Working capital is a company’s residual current assets after deducting its current liabilities. In simpler terms, it is a company’s current assets minus its current liabilities.
However, the above is the simplest definition of the term. In essence, working capital represents all of a company’s residual current assets after using them to repay its current liabilities.
Working capital is a crucial metric for companies and stakeholders. Through this ratio, it is possible to assess a company’s ability to pay its current liabilities using its current assets alone. Since both of these are liquid components, they contradict each other in similar regards. Once calculated, a company’s working capital provides an overview of its short-term financial health.
Working capital also measures a company’s capacity to clear its short-term debts within a year. Both current assets and liabilities are short-term. Therefore, this metric can be a significant indicator of a company’s liquidity position. Similarly, working capital is beneficial in assessing a company’s operational efficiency. Both current assets and liabilities usually relate to operations. Therefore, they also throw light on a company’s operations.
Overall, working capital is a financial metric related to a company’s operating liquidity. Usually, it is positive, meaning a company’s current assets will outweigh its current liabilities. In some cases, however, it can also be negative. It occurs when a company’s current liabilities exceed its current assets. Both positive and negative working capital can provide valuable insights into a company’s operations.
What are the components of Working Capital?
Working capital has two fundamental components, current assets and current liabilities. Therefore, it is crucial to understand what each of these is.
Current Assets
Current assets represent a company’s assets that it can readily convert into cash within a business cycle. More specifically, these are a company’s assets that it will consume within the next 12 months. Current assets are the opposite of non-current assets, which last more than 12 months. Usually, these assets generate from a company’s operations. However, they may also include other items.
Current assets typically include accounts receivables, inventory and cash. For most companies, these three are the primary items that exist in this category. Furthermore, these may consist of short-term investments, prepaid expenses, current assets from discontinued operations, etc. Any assets that companies cannot convert into cash in the next 12 months do not fall under this category.
Current Liabilities
Current liabilities are similar to current assets. These include debts and expenses that companies expect to repay in the next 12 months. Like current assets, current liabilities also typically generate from a company’s operations. Current liabilities are the opposite of non-current liabilities, which are obligations lasting longer than 12 months.
Current liabilities typically include accounts payable, accrued expenses and income tax payable. These three items come from a company’s operations. However, it may also include short-term debts, dividends payable, the current portion of leases, etc. Like with current assets, if a liability lasts for longer than 12 months, it won’t fall under current liabilities.
How to calculate Working Capital?
The formula for working capital comes from its definition. As mentioned, working capital includes a company’s current assets minus its current liabilities. Based on this definition. The working capital formula will be as follows.
Working Capital = Current Assets – Current Liabilities
Companies can also expand this formula by replacing current assets and current liabilities with the items within those categories. For example, a company has accounts receivable, inventory, cash, accounts payable, accrued expenses and income tax payable. The formula will be as follows.
Working Capital = (Accounts Receivable + Inventory + Cash) – (Accounts Payable + Accrued Expenses + Income Tax Payable)
Regardless of how the working formula looks for a company, the information required to calculate it is available on the balance sheet. Therefore, calculating a company’s working capital is straightforward and doesn’t require much work. In some cases, companies may also use the current ratio to calculate the working capital.
Current Ratio
The components of the current ratio are similar to the above working capital formula. However, instead of subtracting current liabilities from current liabilities, it takes a ratio of both. Unlike the above formula for working capital, the working capital ratio does not provide a monetary amount. Instead, it provides a comparative number.
The current ratio has an advantage over the working capital formula. While the working capital formula above does provide an absolute figure, it does not mean anything by itself. However, the current ratio can be useful since there is an ideal ratio that it must reach. Most experts believe it better for the current ratio to be above 1.
The current ratio formula is as below.
Current Ratio = Current Assets / Current Liabilities
Like the above working capital formula alternative, companies can expand the current ratio formula as well.
Example
A company, ABC Co., has the following items in its balance sheet under current assets.
| Particulars | Amount |
| Short-term investments | $10 million |
| Accounts receivable | $20 million |
| Prepaid expenses | $5 million |
| Inventory | $30 million |
| Cash and bank balances | $25 million |
| Total | $90 million |
Similarly, the company has the following items in its current liabilities.
| Particulars | Amount |
| Short-term debts | $30 million |
| Accounts payable | $20 million |
| Accrued expenses | $5 million |
| Income tax payable | $5 million |
| Total | $60 million |
Based on the above information, ABC Co.’s working capital will be as follows.
Working Capital = Current Assets – Current Liabilities
Working Capital = $90 million – $60 million
Working Capital = $30 million
Based on the available data, there is no indication of whether the above is a good or bad working capital. ABC Co. can use this data comparatively with similar companies to get better information. Furthermore, the company can use this figure in several ratios for more meaningful results. However, the current ratio may provide an insightful outcome and is as below.
Current Ratio = Current Assets / Current Liabilities
Current Ratio = $90 million / $60 million
Current Ratio = 1.5
Since ABC Co.’s current ratio is higher than 1, it means the company is doing good. However, for the best analysis, this ratio must be compared and analyzed against other similar companies.
What is the importance and limitations of Working Capital?
Working capital can be of significant importance to companies. As mentioned, it is an indicator of a company’s liquidity. Similarly, it can help companies understand their current assets and liabilities better. Based on this information, these companies can make better decisions. Calculating working capital can also provide crucial insights into a company’s cash position.
By calculating working capital, therefore, companies can predict cash surplus and cash deficit. Working capital also helps companies boost short-term profits. Furthermore, it helps improves creditworthiness which can help raise more finance. A decent working capital position can also help increase a company’s reputation among stakeholders, especially investors.
However, working capital has some limitations. For companies that are capital-intensive, this figure will generally be lower. Therefore, working capital may not be as insightful for them. Similarly, it includes some items that are less liquid, for example, inventory. Another fundamental limitation of the working capital is that it does not provide an absolute measure unless used comparatively.
Conclusion
Working capital represents a company’s current assets minus its current liabilities. It is a crucial metric to measure a company’s operational efficiency. Similarly, working capital requires two components, current assets, and current liabilities. There are several reasons why working capital is of high importance. However, it can have some limitations as well.
