Working Capital

Working Capital measures a company's short-term liquidity and ability to meet its near-term obligations. It represents the capital available for day-to-day operations. The formula is Current Assets minus Current Liabilities.

Current assets include cash and equivalents, accounts receivable, inventory, prepaid expenses, and short-term investments. Current liabilities include accounts payable, short-term debt, accrued expenses, current portion of long-term debt, and taxes payable.

For example, if a company has $50 million in cash, $100 million in accounts receivable, and $80 million in inventory, its total current assets equal $230 million. If it has $70 million in accounts payable, $30 million in short-term debt, and $20 million in accrued expenses, total current liabilities equal $120 million. The resulting working capital would be $110 million.

When interpreting working capital, positive working capital means the company can cover short-term obligations. Negative working capital may indicate liquidity issues, though some efficient businesses operate this way. High working capital is safe but may indicate inefficiency. Low working capital is efficient but may carry more risk.

The working capital ratio, also called the current ratio, equals current assets divided by current liabilities. A ratio above 1.0 means positive working capital, while a ratio above 2.0 is generally considered safe. This ratio varies significantly by industry.

Working capital matters for several reasons. It indicates liquidity by showing whether the company can pay bills. It reflects operational efficiency through cash cycle management. It shows growth capacity by revealing available capital for expansion. It affects creditworthiness and borrowing ability.

The working capital cycle flows from cash to inventory to receivables and back to cash. A shorter cycle is more efficient, while a long cycle ties up capital.

Industry differences affect typical working capital needs. Retail and manufacturing businesses usually require high working capital due to inventory needs, while software and services companies typically need low working capital since they don't hold inventory.

Negative working capital can actually be advantageous for some businesses like Walmart that collect cash from customers before paying suppliers.