What is Working Capital?
Are you an investor or business owner? Working capital is an effective way of determining a company's financial health. Read about it here.
Working capital is an essential factor for every business. It shows whether or not a business is using its asset efficiently or whether it can satisfy its debts. Whether you are an investor, a creditor, or a manager, it is essential to know what a working capital is to determine the financial and legal health of the business and to plan ahead.
What is it?
Working capital or net working capital (NWC) is a measure of a business’ liquidity and short-term financial health. As a result, it shows whether or not a business is able to pay off its short-term obligations (due within 12 months) by subtracting the business’ current assets with its current liabilities.
Current assets is a type of asset that is shown in the balance sheet. It includes all of the asset a business has that are expected to be converted to cash within 12 months. It includes:
- Cash equivalents
- Accounts receivable
- Marketable securities
- Prepaid expenses
- Other liquid assets (e.g. money market instruments)
Current assets are important as you can use them pay for operational expenses and short-term liabilities.
Conversely, current liabilities are short-term financial liabilities (e.g. debts). In other words, they are liabilities that are to be paid to creditors within 12 months. It includes:
- Accounts payable
- Unearned revenue
- Accrued expenses
- Taxes payable
- Interest payable
- Dividends declared
- Short-term loans
Current liabilities are often paid off using current assets due to its similar short-term nature.
There are two ways in which you can calculate the working capital of a business:
Working Capital Formula
The first method is by subtracting the current assets with the current liabilities. This is shown below:
Working Capital = Current Assets – Current Liabilities
If the sum is positive, that means a business has more current assets than liabilities, allowing it to pay its short-term obligations and use the excess asset to invest and grow the business. If the sum is negative, then the business has more short-term debt than its liquid assets, which may lead to insolvency.
Another method to calculate the net working capital is by using the Current Ratio. You can calculate the ratio by dividing current assets with current liability. This is shown below:
Current Ratio = Current Assets / Current Liabilities
Generally, a current ratio above 1 means that the business is able to satisfy its short-term obligations whereas a current ratio lower than 1 shows a business’ inability to pay off its debts. However, an acceptable ratio depends on the industry average. A much higher ratio means that the business is not efficiently using its short-term assets to grow.
Why is it important?
Knowledge of a business’ liquidity is beneficial for many people.
If you are a creditor, a business with a negative ratio may be considered to be risky as it shows that the business cannot pay its short-term debts. Additionally, if a business is unable to repay its debt, its business credit will be affected.
If you are a manager in the business, it is necessary to understand the significance of its ratio. If the ratio is too high compared to its industry average, then the business is not maximising its assets’ operational efficiency. In the event that it is too low, the business will be at risk of bankruptcy or insolvency.
If you are an investor, a high ratio may show a business’s flexibility and ability to invest and grow more. On the other hand, a low ratio may be considered to be risky.
Although a substantial working capital means that a business is able to satisfy its short-term debt, it is important to note that it isn’t always a good thing. This is because it means that the business is not investing its excess assets. Ultimately, you will need to observe industry comparables and averages to accurately show whether or not the business’ financial health is good or not. If you want further advice on how to maximise your working capital, it is worth speaking to a business lawyer.
Ryan currently works in the content team as a Legal Intern for Lawpath. He is in his third year of a Bachelor of Law and Business degree at UTS.