working capital

What is working capital?

Working capital is the difference between a business's current assets and current liabilities. In accounting, the working capital total is usually derived from the figures for current assets and current liabilities recorded on the balance sheet. For example, a company 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. It is the funds a business needs to pay its short-term obligations, such as bills, debts, and operating expenses, including wages.

How working capital is calculated

Current assets, such as cash and cash equivalents, receivables, inventory and supplies, are assets that can usually be disposed of within a year. Current liabilities must be paid within a year, compared to long-term liabilities like mortgages. They include items such as accounts payable, short-term debt and accrued expenses. Alternative formulas exclude cash or only use payables, receivables and inventory because they more closely reflect daily operations.

The working capital ratio (or current ratio) is a common metric used to gauge the optimal amount of working capital. It's possible to have too much working capital -- essentially, funds that are sitting idle, are not needed for short-term obligations and could instead be invested for potentially higher returns. A ratio below 1 indicates negative working capital, while 2 or above (twice as many current assets as liabilities) may indicate excess assets.

Most organizations aim to have a ratio between 1.2 and 2, though it varies by industry. High-turnover industries like supermarkets and fast food can get by with negative working capital because money often comes in faster than it goes out. But manufacturers of heavy equipment can't raise cash quickly because their goods are often paid for in long-term payments.

The working capital ratio is affected by numerous other factors, such as how much of it is held in cash and marketable investments -- which can be easily accessed to pay bills -- versus slow-moving inventory.

A company with more cash than inventory can tolerate a lower ratio. E-commerce companies with consistent sales can usually keep minimal working capital because their customers typically pay with credit cards when placing orders. In contrast, companies in industries where 60-day payment terms are common will need more working capital.

Declining working capital is usually seen as a red flag about an organization's financial soundness because it could indicate, for example, declining accounts receivable from a drop in sales.

Working capital also provides a window into operational efficiency. A low ratio might be the result of poor inventory management or inefficient debt collection.

Difference between cash flow and working capital

Although cash is one of the current assets that comprises working capital, cash flow is instead a measure of how much cash is flowing in and out of the business. In the strict accounting sense, cash flow is the difference between cash available at the beginning of an accounting period -- the opening balance -- and the closing balance at the end of the period.

Most companies prepare a statement of cash flows. 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 the 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 can also include less common reasons for outflows, such as settlement of 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 result in cash inflows. Financing might include loans for buying equipment but also selling and reacquiring stock in the company.

A negative cash flow indicates a company is having trouble paying its bills, which is why most companies strive for a positive cash flow. Companies with negative cash flow will usually look for more working capital, often in the form of a short-term loan or line of credit.

Technology for managing working capital

Working capital management is a discipline in managerial accounting that involves tracking working capital and optimizing it by adjusting current assets and liabilities. For example, a company can 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, indicates how quickly sales are being converted into cash, while the inventory turnover ratio compares the cost of inventory against revenue.

The most common technology used in working capital management is the accounting software a company uses for financial management and reporting, either standalone or as a module in ERP. These accounting systems provide the raw data that goes into the working capital total and ratio, but typically additional financial analytics tools are needed, such as spreadsheets or business intelligence platforms. Some ERP vendors and niche vendors offer specialized analytics and working capital management software. In addition, financial modeling software provides predictions and what-if scenarios.

Working capital and tools for managing it are also available in procurement platforms and from supply chain finance providers who act as middlemen for third-party financing of accounts receivable. The idea is to lengthen or shorten payment cycles to improve the cash flows of buyers and sellers.

Inventory optimization software is one of several inventory management tools that can help minimize this key component of current assets without risking shortages that can lead to lost sales that depress accounts receivable. Shipping delays and penalties can raise the liabilities component of working capital.

Companies also have more fine-grained analytical tools at their disposal, such as the ABC classification for identifying the inventory that provides the greatest business value and merits the most attention.