Working capital is exactly what it sounds like - it's a financial term that describes the amount of capital that is accessible to companies that allows them to run a business on a daily basis.
The beauty of working capital is its simplicity. For example, its formula is as efficient as an accounting term can get: net working capital equals current assets minus current liabilities (more on that below.)
What's not so simple for corporate financial executives is getting a good grip on a company's near-term financial health and how efficiently a company is operating, from a financial point of view.
That's where working capital can help. Once its ratio is calculated, company decision-makers will know whether or not they have the necessary financial capital to handle short-term debt and if it can manage its day-to-day today expenses going forward, on the near- and long-term.
What Are the Components of Working Capital?
The term "working capital" defines those expenses that are required in key areas like inventory, available cash, accounts payable, and accounts receivable.
Working capital comes from various company financial factors, including all revenues available, all debt and inventory, and other corporate payments like those to suppliers and vendors.
Mostly though, working capital relies on two primary components to measure a company's day-to-day financial standing - assets and liabilities.
Working Capital and Assets
Organizational assets help define a company's financial value - they're the economic assets that a business has under its control. Assets also have some flexibility for corporate financial managers, as they can offer benefits today or down the road.
Organizational assets may include cash, inventory, money coming in via accounts receivable, real estate (including buildings), and company equipment. By and large, a company's assets are deemed current when they are used immediately (for example, being liquidated into cash) or if those assets are to be used in the near term - like in six months or one year.
Working Capital and Liabilities
Any debt owed by a business is considered to be a financial liability. For instance, salaries, taxes, money owed to vendors and partners via accounts payable, and other debts are considered to be organizational liabilities. Like assets, liabilities may have a short shelf life, and may be deemed as current if any debts are expected to be made within a few months or a single year.
After calculating working capital and determining an outcome, a company can then make the decisions on where and how to properly deploy working capital.
Some outcomes, however, are more common than others.
• You have negative working capital. If you have negative working capital, meaning you have fewer assets than liabilities, you may face several serious corporate financial risks.
For example, having negative working capital may mean you risk not paying back short term debt that your company owes. With no assets to cover that debt, a business may have to turn to traditional forms of company financing liked fixed-rate loans, lines of credit, or even cash advances from a partnering financial institution.
• A company may elect to sell an asset to cover the cost of short term debt. Land, a building, equipment, or even a percentage of a product or service line may be sold to get the cash a company requires to meet its financial obligations. A publicly-traded company may well opt to sell more of its company stock to raise cash, as well.
In contrast, a business with positive working capital, meaning it has more assets than liabilities, has significantly more financial leverage than a company with negative working capital.
For instance, a company with positive working capital doesn't have to resort to selling its stock shares or borrowing money from a bank to cover short-term debt obligations.
With more working capital on hand, a company can flex its financial muscles somewhat and deploy the cash to new product research, new hires, building a new facility, buying much-needed equipment, or simply keeping the cash on reserve for a rainy day.
All of the above strengthens a company's financial position, giving it more options - and more opportunities - to grow its line of business.
It's worth noting that tight working capital cycles, even if they're negative cycles, don't do much harm to a company's financial health.
If you're only waiting several days as opposed to several weeks to cover company debt obligations, you still have plenty of time to focus on growth and opportunity, rather than finding ways to meet a debt obligation to a supplier or vendor.
Ideally, though, it's best to rake in account receivables as quickly as possible and defer paying regular debts as long as possible, so short term debt scenarios aren't as prevalent, and the need to focus on working capital isn't as onerous and as regular an issue.
Why Would a Business Require Extra Working Capital?
There is no shortage of reasons why a company may need more working capital, but some reasons are more common than others:
• You're a manufacturer (like Hermès (HESAY) or Columbia (COLM) - Get Report ) who ships scarves and gloves to retailers in advance and gets paid later. Or, you're an online retail platform like Amazon (AMZN) - Get Report which collects and ships products in advance of collecting from its online sellers.
By waiting for payment after handling your end of the deal, you may be risking a negative working capital ratio. Of course, if you're dealing with the volume of Amazon, a negative working capital ratio isn't as big an issue as a smaller company with the same business model.
• You're in the "seasonality" business. A farm that grows a thousand Christmas trees or 10,000 ears of corn is very much a seasonal business.
In that regard, the farms need more money to grow those trees and corn and have to wait months before its crop bears financial fruit. A seasonal company is a good example of a business that requires extra capital upfront and has to wait a long financial cycle before it can cover its debts.
A good seasonal company, however, has been around a long time, puts ample cash in reserve or at least has a good relationship with its creditors, and can weather a long delay in getting paid for its products or services, making working capital less of an issue.
• You do business with the government. Uncle Sam is notoriously slow in paying its vendors and business partners.
Consequently, if your company's chief customer is the government, you may wait a while to get paid, even though you still need capital to pay your own suppliers, keep regular debts in current payment order, and face other financial obligations.
In that instance, a regular line of credit with a trusted financial institution is a good way to add working capital while you're waiting in line for Uncle Sam to cut a check.
• You purchase your supplies in large lots or bulk. Any consumer knows the drill at a Costco (COST) - Get Report or Sam's Club. You go there for one reason - to buy in bulk. If you're a company that buys in bulk, like the farmer who buys a silo full of seed to grow corn, additional working capital enables that farmer to buy that seed at a significant discount, thus saving money.
• Your company is project-based. Let's say you own an advertising company that's just starting out and doesn't have a full roster of clients yet. When a big project does come along and then one more three months after that, you'll need working capital to hire, for example, freelance copywriters and designers to help meet the project goals and get the work to the client in time.
In that scenario, having working capital on hand for the "busy times" can be a real advantage for a project-based company - at least, that is, until the client and projects grow more abundant as your ad agency grows.
How to Calculate Working Capital
As noted above the basic formula for calculating working capital is as follows:
Current assets/current liabilities = working capital
Using real numbers let's put that working capital calculus into play and see how it works in the real world.
Let's say company NOP has current assets of $1 million and current liabilities of $500,000. In that scenario, NOP's working capital is 2:1 - which is a highly positive working capital ratio.
But if your company's working capital ratio is $500,000 in assets and $1 million in liabilities, the ratio of 1:2 means the company has some work to do to meet its debt obligations and get back on an even corporate financial keel.
With such a negative working capital ratio, it becomes apparent the company in question is having problems paying its bills, and will have to dig deeper into debt (in the form of stock sales, bank loans or lines of credit, for example,) to cover its debts and stay in business.
The Takeaway on Working Capital
Depending on the business you run, and how often you deliver products and services and get paid by customers, knowing your working capital ratio can be a big help in running your business efficiently and with minimal financial hassles.
Consequently, running the numbers regularly and having a firm handle on your assets and liabilities, and how they impact your business operations is a great way to keep your company running smoothly and efficiently, and your debts and obligations handled in an appropriate manner.
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