TheStreet

Don't be fooled by its simple definition. Working capital is a critical, and fairly sophisticated, metric. Whether you're an investor or an entrepreneur you'll need to understand this facet of corporate wealth.

Fortunately, we can help.

What Is Working Capital?

Working capital (otherwise known as "net working capital") is a company's available wealth measured by the difference between its total assets and its total liabilities. As a formula, it is:

Working Capital = Assets - Liabilities

There are two ways of measuring working capital based on how you define "Assets" in the formula.

How to Measure Assets in Working Capital

1. Liquid, or Current, Working Capital

Current working capital is the most common measure of working capital. It defines a company's assets as all of its cash or cash-like property. This would include not only present liquidity, but also property such as cash-equivalents, unpaid accounts, unsold inventory and liquid securities.

Current working capital measures assets available to the company within one year. So, for example, this would exclude accounts payable that are not due within the year under analysis. For incoming debt payments it would not include the total principal owed to the company, just those payments due during the year.

This is essentially a measure of the cash a company has on hand or can easily acquire to pay its debts. It is also sometimes known as the "quick ratio."

2. Total Working Capital

Total working capital is a less common measure of working capital.

The total working capital measure uses every asset of value that a company controls. This includes not only cash and cash-like properties, but also capital investments like equipment and land, all securities (not just those which the company can quickly liquidate), salable intellectual property and virtually every other asset that the company could sell if it chose.

As with current working capital, total working capital only measures the company's holdings for the year under analysis. So, again, it will include only accounts and debts due within that period.

This is a measure of a company's entire value. It is less favored because it doesn't effectively measure the amount of cash a company can use to pay its current debts. The assets included in total working capital are generally harder to transfer into cash. As a result, while this metric gives you a good sense of the company's total present value if put on the auction block, it provides less information about the company's access to operating cash.

How to Measure Liabilities in Working Capital

In the working capital formula, "liabilities" represents a company's current liabilities. This means debts, payments and other financial obligations due within the year under analysis.

Liabilities include all spending. In addition to debt payments it includes line-items such as payroll, taxes, costs of goods, rent on all leases and all other anticipated expenses. This would not include expenses which cannot be reasonably anticipated.

For example, if a warehouse caught fire you would include all expenses associated with that event. However, you would not include an anticipatory line item in case of potential fire damage or catastrophic loss.

Working Capital Ratio

The second working capital formula is called the Working Capital Ratio.

Where working capital is the total measure of a company's available assets after paying its liabilities, the working capital ratio expresses this as a dollar-to-debt proportion. A ratio above 1.0 indicates that the company has more than $1 in assets for each $1 it has in debt. A ratio below 1.0 indicates the opposite, that the company has less money than it needs to service its current liabilities.

Generally speaking, banks look for a working capital ratio between 1.2:1 and 2.0:1. A ratio below 1.2 means that the company has little excess capital. Reinvestment will be slow and the company doesn't have much of a cash buffer against unexpected problems. A ratio above 2.0 shows that the firm has plenty of cash to pay its debts and handle problems, but potential investors will ask why it hasn't reinvested all of this extra cash.

The formula to calculate the working capital ratio is:

Working Capital Ratio = Assets / Liabilities

An Example of Working Capital

Let's walk through a hypothetical current working capital calculation for Company A.

1. Assets

Company A has cash holdings in the amount of $50,000.

It has stock holdings in the amount of $15,000. It holds another $20,000 in long term Treasury Bonds.

It has unsold inventory in the amount of $50,000.

It has accounts currently receivable in the amount of $100,000. Customers also owe another $250,000 on bills that will come due in two years.

It owns $250,000 in real estate and vehicles.

2. Liabilities

Company A has operational costs in the amount of $15,000. This includes leases, costs of goods and other costs of doing business.

It will pay $100,000 in salaries and benefits this year. It has a pension program which will pay its existing employees $25,000 per year upon their retirement.

It will pay $25,000 in taxes this year.

It has corporate debt worth a total of $500,000. It owes $25,000 in payments on this debt this year.

It has $5,000 in bills for repairs and upgrades that it made to one of its shops this year.

3. Calculating Assets and Liabilities

First, we assess Company A's current assets. To do this we only account for the cash that it has or will collect in this year, plus the assets that it can easily convert into cash.

This means that we will discount its real estate and vehicle holdings, as these are not considered semi-liquid assets. We will also discount its Treasury bonds as those have a fixed term, although some analysts might include them as a marketable securities. Finally, we will discount the accounts which are not payable to Company A within this calendar year.

Company A therefore has current assets in the amount of $50,000 + $15,000 + $50,000 + $100,000 = $215,000.

Next we assess Company A's current liabilities. To do this we only account for the debts and expenses it will pay in this year.

This means that we will discount its total corporate debt and its pension program, as neither of these expenses are due within the calendar year.

Company A has current liabilities in the amount of $15,000 + $100,000 + $25,000 + $5,000 = $145,000.

4. Final Working Capital

Company A's Working Capital is: $215,000 (Current Assets) - $145,000 (Current Liabilities) = $70,000.

5. Final Working Capital Ratio

Company A's Working Capital Ratio is: $215,000 (Current Assets) / $145,000 (Current Liabilities) = 1.48:1.

What Working Capital Means

Working capital measures a company's current, available liquidity. The working capital ratio measures the company's efficiency.

1. Available Liquidity

Measuring a company's net working capital tells you how much capital it has on hand to pay its debts, manage a crisis and reinvest in its future. As a threshold matter, a company with negative working capital doesn't have enough cash on hand to cover its own expenses. Except in unusual cases this is a red flag for potential investors. (In particular, however, retail firms have been known to operate quite successfully with negative working capital.)

Beyond that, the net working capital tells investors how much extra cash the firm has on hand. It lets them judge whether the company seems to have a comfortable buffer against future potential losses, and if the net working capital indicates a potential period of reinvestment and growth.

2. Operating Efficiency

The working capital ratio indicates how efficiently a company spends its money. A low ratio indicates that the firm spends almost every dollar that it brings in. This leaves it with little margin for error or reinvestment. An overly high ratio indicates that the firm is hoarding cash. Both of these approaches are inefficient from a business standpoint.

What's more, working capital and the working capital ratio can tell you whether a company's revenue stream represents the true value of the firm. For example, investors have increasingly begun asking questions about Uber's business model. Despite that company's enormous customer base and cash inflows, it still can't keep up with its own expenses and debts.

Revenue can't tell that story. Working capital will.

3. Reading Working Capital vs. Working Capital Ratio

Net working capital tells investors about the firm's raw spending power. The working capital ratio puts that spending power in the context of the firm's size and expenses. Each of these are one essential piece of the picture.

Net spending power tells investors about the firm's potential for growth and development. Understanding that the firm has, say, a 1.5:1 capital:liabilities ratio doesn't tell an investor whether that firm can open a new store. Only seeing that this company has $5 million in untapped assets can do that.

The working capital ratio, however, puts that raw spending power in context. A local diner with $5 million in legitimate net working capital would have investors beating down the doors. If Apple (AAPL) posted a net working capital of $5 million, on the other hand, it would cause a panic in the market.

The more money a firm spends, the more it has to make. Otherwise, something has gone wrong. That's what the working capital ratio can tell you.