Working capital is the difference between current assets and current liabilities of a business. In accounting, the total working capital is generally derived from the figures for current assets and current liabilities recorded on the balance sheet. For example, a business with $ 200,000 in current assets and $ 100,000 in current liabilities has working capital of $ 100,000. Working capital is both a critical resource and a measure of financial health. These are the funds a business needs to pay off its short-term obligations, such as bills, debts, and operating expenses, including salaries.
How working capital is calculated
Current assets, such as cash and cash equivalents, receivables, inventories and supplies, are assets that can generally be disposed of within one year. Short-term debts must be paid within one year, compared to long-term debts like mortgages. They include items such as accounts payable, short-term debt, and accrued liabilities. Alternative formulas exclude cash or only use debts, receivables, and inventory because they more closely reflect day-to-day operations.
The working capital ratio (or current ratio) is a common measure used to assess the optimal amount of working capital. It is possible to have too much working capital – essentially, funds that sit idle, are not needed for short-term bonds and could instead be invested for potentially higher returns. A ratio less than 1 indicates negative working capital, while 2 or more (twice as many current assets as liabilities) may indicate excess assets.
Most organizations aim to have a ratio between 1.2 and 2, although it varies by industry. High turnover industries like supermarkets and fast food restaurants can get by with negative working capital as money often comes in faster than it goes out. But heavy equipment manufacturers can’t raise funds quickly because their goods are often paid for in long-term payments.
The working capital ratio is affected by many other factors, such as the amount held in cash and marketable investments – which can be easily accessed to pay the bills – compared to slow moving inventory.
A business with more cash than inventory can tolerate a lower ratio. Ecommerce businesses with consistent sales can usually keep working capital minimal, as their customers typically pay with credit cards when placing orders. In contrast, businesses in industries where 60-day payment terms are common will need more working capital.
Declining working capital is generally seen as a red flag to an organization’s financial strength, as it may indicate, for example, a decline in accounts receivable due to a decline in sales.
Working capital also provides a window into operational efficiency. A low ratio can be the result of poor inventory management or inefficient debt collection.
Difference between cash flow and working capital
While cash is one of the current assets that make up working capital, cash flow is more of a measure of how much cash flows in and out of the business. In the strict sense of accounting, cash flow is the difference between the cash available at the start of an accounting period – the opening balance – and the closing balance at the end of the period.
Most businesses prepare a cash flow statement. It provides another view of financial health beyond what can be discerned from the income statement and balance sheet. The two main financial reporting standards, generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS), both require companies to file statements of cash flows.
The cash balance is generally affected by three important functions of the organization: operations, investing and financing. The operations component includes, for example, sales, payroll, rent, and invoices, but may also include less common reasons for cash outflows, such as settling lawsuits. Investments include the purchase of securities and long-term physical assets, which cause an outflow of cash, but also gains on invested funds, which can lead to inflows of cash. Financing can include loans for the purchase of equipment, but also the sale and repurchase of company shares.
Negative cash flow indicates that a business is struggling to pay bills, which is why most businesses strive for positive cash flow. Businesses with negative cash flow will typically seek more working capital, often in the form of a short-term loan or line of credit.
Working capital management technology
Working capital management is a discipline of management accounting that involves tracking working capital and optimizing it by adjusting current assets and liabilities. For example, a business may try to speed up debt collection to raise cash (an asset) while refinancing a loan to reduce monthly payments (a liability). Another financial metric, the collection ratio, shows how quickly sales are converted to cash, while the inventory turnover ratio compares the cost of inventory to revenue.
The most common technology used in working capital management is the accounting software that a company uses for financial management and reporting, either stand-alone or as a module in ERP. These accounting systems provide the raw data that goes into the total and the working capital ratio, but additional financial analysis tools are usually needed, such as spreadsheets or business intelligence platforms. Some ERP vendors and niche vendors offer specialized working capital analysis and management software. In addition, the financial modeling software provides forecasting and what-if scenarios.
Working capital and the tools to manage it are also available in procurement platforms and from supply chain finance providers who act as intermediaries for third party accounts receivable finance. The idea is to lengthen or shorten payment cycles to improve cash flow for buyers and sellers.
Inventory optimization software is one of many inventory management tools that can help minimize this key part of current assets without risking a shortage that can lead to lost sales that depress accounts receivable. Shipping delays and penalties can increase the liability component of working capital. Companies also have finer-grained analysis tools, such as the ABC classification, to identify the inventory that offers the greatest business value and deserves the most attention.