Working Capital = current assets minus current liabilities
So you may be wondering what is Working Capital? It is the difference between a companies current assets (cash, accounts receivable etc) and it’s current liabilities (accounts payable etc).
Working Capital is used to review a company’s short term financial health, by looking at it’s liquidity and how efficiently it is using it’s assets.
A company with positive working capital ( current assets being higher than current liabilities) has the potential to grow or survive any unforeseen problems, as they have more than enough liquidity to pay creditors.
A company with negative working capital is at risk of bankruptcy in the future, as they may be unable to pay creditors. Even if they avoid bankruptcy, they may suffer from a poor credit rating (so higher interest on loans) and have businesses refuse to act as suppliers.
Very high positive working capital can be a bad thing. Too much cash might mean you’re not investing enough into the business. If you have too much inventory, it may mean you would of been better served investing the cash in something else.
How to Calculate Working Capital
The calculation for Working Capital is simple – current assets minus current liabilities.
Why is Working Capital Important
Working Capital is an important metric for a business to measure because it’s important to keep the business solvent. Meaning they have enough current assets to cover all their liabilities that are due in the next 12 months.
It allows them to calculate the impact on the businesses solvency if a variety of scenarios occur. Such as if they decide to heavily invest in a new product, a new factory or a new market. They will need to make sure that there will still be enough cash coming into the bank to fund these things.
It also allows companies to prepare for less idea situations, such as a a reduction in sales. If sales go down, will they be carrying too much stock and eventually unable to pay creditors?