What is Working Capital?
Working capital is money available to a company for day-to-day operations. Simply put, working capital measures a company's liquidity, efficiency, and overall health. Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and other short-term accounts, a company's working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection, and payments to suppliers.
Working Capital Formula
You can calculate the working capital of an organization by using the following formula:
Let's walk through an example where we can calculate a company's working capital by looking at Company XYZ's simplified balance sheet:
Using the working capital formula and the information above from the table above, we can calculate that Company XYZ's working capital is:
Working Capital = $160,000 - $65,000 = $95,000
In this example, we see that the company's working capital is $95,000 -- a positive working capital.
Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately. Negative working capital generally indicates a company is unable to do so.
This is why analysts are sensitive to decreases in working capital; they suggest a company is becoming overleveraged, is struggling to maintain or grow sales, is paying bills too quickly, or is collecting receivables too slowly. Increases in working capital, on the other hand, suggest the opposite.
There are several ways to evaluate a company's working capital further, including calculating the inventory-turnover ratio, the receivables ratio, days payable, the current ratio, and the quick ratio.
What is the Working Capital Ratio?
The working capital ratio is another way to compare a company's current assets to its current liabilities. Unlike the traditional working capital formula (current assets - current liabilities), the working capital ratio puts current assets in the numerator and current liabilities in the denominator.
Here's the formula for the working capital ratio:
Working capital ratio = current assets / current liabilities
Working capital ratio = (cash + short-term investments + inventory + accounts receivables) / (short-term notes + accounts payables)
This ratio is usually expressed as a multiple. A working capital ratio of 1.0 means that a company's current assets are equal to its current liabilities. A working capital of 2.0 means that company has twice the amount of current assets as it does current liabilities, while a working capital of less than 1.0 indicates a negative working capital where the company's current liabilities exceed its current assets.
Depending on the analyst you ask and the company's industry, a working capital ratio between 1.1 and 2.0 typically indicates a healthy working capital ratio where a company is managing its cash wisely and minimizing its risk of defaulting on its bills. A working capital ratio of more than 2.0 with a relatively low cash amount may mean the company is moving its inventory too slowly, collecting its receivables too slowly, or paying its vendors too quickly -- all of which could lead to cash shortage and repayment problems if cash levels are low.
Smart Working Capital Management
One of the most significant uses of working capital is inventory. The longer inventory sits on the shelf or in the warehouse, the longer the company's working capital is tied up.
When not managed carefully, businesses can grow themselves out of cash by needing more working capital to fulfill expansion plans than they can generate in their current state. This usually occurs when a company has used cash to pay for everything, rather than seeking financing that would smooth out the payments and make cash available for other uses. As a result, working capital shortages cause many businesses to fail even though they may actually turn a profit. The most efficient companies invest wisely to avoid these situations.
Analysts commonly point out that the level and timing of a company's cash flows are what really determine whether a company is able to pay its liabilities when due. The working-capital formula assumes that a company really would liquidate its current assets to pay current liabilities, which is not always realistic considering some cash is always needed to meet payroll obligations and maintain operations. Further, the working-capital formula assumes that accounts receivable are readily available for collection, which may not be the case for many companies.
It is also important to understand that the timing of asset purchases, payment and collection policies, the likelihood that a company will write off some past-due receivables, and even capital-raising efforts can generate different working capital needs for similar companies. Equally important is that working capital needs vary from industry to industry, especially considering how different industries depend on expensive equipment, use different revenue accounting methods, and approach other industry-specific matters.
Finding ways to smooth out cash payments in order to keep working capital stable is particularly difficult for manufacturers and other companies that require a lot of up-front costs. For these reasons, comparison of working capital is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.
Is it good to have a large amount of working capital?
Not always. If you're include a company's "rainy day" reserve cash in its assets within the working capital formula (current assets - current liabilities), then a large amount of working capital is a good indicator that the company will be financially able to repay its payables and other short-term debt even if business were to suddenly dry up.
However, if you're using only a company's cash needed for "day-to-day" operations in the current assets part of the working capital formula, then a large amount of working capital with a relatively small amount of cash could mean problems. It could mean the company is a) having trouble moving its inventory, b) collecting its receivables from customers too slowly, or is c) paying its vendor's payables too quickly. If the company has little cash available and it's unable to do well in those three categories, the company could run into problems paying its bills and vendors.
Is a negative working capital amount always a bad sign?
While a negative working capital amount typically warns that a company has more short-term debt than it has in cash and other assets, it sometimes be a smart use of cash resources depending on the company's business model.
In Dell's heyday around 2004, for example, the company was able to assemble its personal computers and sell them directly to customers more than 30 days before the PC maker needed to pay its suppliers.
While these sales gave Dell large accounts payable balances (and typically a negative working capital balance), the company was able to make and sell computers by essentially using its suppliers' money without ever having to dip into its own cash reserves!