WORKING CAPITAL

What Is Working Capital?

Working capital is calculated by subtracting current liabilities from current assets, as listed on the company’s balance sheet. Current assets include cash, accounts receivable and inventory. Current liabilities include accounts payable, taxes, wages and interest owed.

Why is Working Capital Important?

Working capital is used to fund operations and meet short-term obligations. If a company has enough working capital, it can continue to pay its employees and suppliers and meet other obligations, such as interest payments and taxes, even if it runs into cash flow challenges.

Working capital can also be used to fund business growth without incurring debt. If the company does need to borrow money, demonstrating positive working capital can make it easier to qualify for loans or other forms of credit.

For finance teams, the goal is twofold: Have a clear view of how much cash is on hand at any given time, and work with the business to maintain sufficient working capital to cover liabilities, plus some leeway for growth and contingencies.

Advantages of Working Capital

Working capital can help smooth out fluctuations in revenue. Many businesses experience some seasonality in sales, selling more during some months than others, for example. With adequate working capital, a company can make extra purchases from suppliers to prepare for busy months while meeting its financial obligations during periods where it generates less revenue.

For example, a retailer may generate 70% of its revenue in November and December — but it needs to cover expenses, such as rent and payroll, all year. By analyzing its working capital needs and maintaining an adequate buffer, the retailer can ensure it has enough funds to stock up on supplies before November and hire temps for the busy season while planning how many permanent staff it can support.

How to Calculate Working Capital

Working capital is calculated as current assets minus current liabilities, as detailed on the balance sheet.

Positive vs. Negative Working Capital

A company has positive working capital if it has enough cash, accounts receivable and other liquid assets to cover its short-term obligations, such as accounts payable and short-term debt.

In contrast, a company has negative working capital if it doesn’t have enough current assets to cover its short-term financial obligations. A company with negative working capital may have trouble paying suppliers and creditors and difficulty raising funds to drive business growth. If the situation continues, it may eventually be forced to shut down.