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.