How to Calculate Working Capital (with Example)

Working capital is a crucial financial metric used to assess the operational efficiency and short-term financial health of a company. It is defined as the difference between current assets and current liabilities. Essentially, working capital represents the amount of capital available to a company to fund its day-to-day operations and meet its short-term financial obligations. A company with sufficient working capital can ensure that it has enough liquidity to cover its short-term liabilities and continue its business activities without facing financial strain.

Definition of Working Capital

Working capital is calculated using the following formula:

Working Capital=Current Assets−Current Liabilities

Current Assets are assets that are expected to be converted into cash or consumed within one year. These include items like cash, cash equivalents, accounts receivable, short-term investments, and inventory.

Current Liabilities are obligations that are due to be settled within one year. These typically include accounts payable, short-term loans, accrued expenses, and the current portion of long-term debt.

Thus, working capital reflects the liquidity available to a business to meet its short-term obligations and operational needs.

Components of Working Capital

Current Assets

Current assets are the resources a company expects to use up or convert into cash within a year. They are crucial to a company’s ability to fund its daily operations. Some of the main types of current assets include:

Cash and Cash Equivalents: This includes actual cash on hand and highly liquid investments that can be easily converted into cash within a short period (e.g., treasury bills, money market funds).

Accounts Receivable: This represents the amounts owed to the company by its customers for goods or services that have been provided on credit. Accounts receivable are expected to be collected within a year.

Inventory: This refers to goods that the company intends to sell or use in its operations within the year. It includes raw materials, work-in-progress, and finished goods.

Short-Term Investments: These are investments that the company intends to sell or convert into cash within a year. They could include stocks, bonds, or other marketable securities.

Prepaid Expenses: These are payments made in advance for goods or services to be received in the future (e.g., prepaid insurance or rent).

Current Liabilities

Current liabilities represent the company's obligations that need to be settled within one year. These liabilities must be met using the company’s current assets. Common types of current liabilities include:

Accounts Payable: This refers to the amounts a company owes to suppliers for goods or services it has received on credit. Accounts payable are expected to be settled within a short time, often 30 to 90 days.

Accrued Expenses: These are expenses that a company has incurred but has not yet paid, such as wages, taxes, or interest on loans.

Short-Term Loans or Notes Payable: This refers to any loans or borrowings that are due for repayment within the year.

Current Portion of Long-Term Debt: This is the part of a company's long-term debt that is due for repayment within the next year. It is considered a current liability because it must be paid off in the short term.

Importance of Working Capital

1. Liquidity and Operational Efficiency

Working capital is a key measure of a company’s liquidity, which refers to its ability to meet its short-term financial obligations. Adequate working capital ensures that a company can continue its operations smoothly without disruptions. If a company’s working capital is too low, it may struggle to pay off its creditors, suppliers, and employees, which can lead to financial distress. On the other hand, a high level of working capital may indicate inefficiency, as the company may be holding too much idle cash or inventory that could be better utilized elsewhere.

2. Financial Health and Stability

Investors, creditors, and analysts use working capital as an indicator of a company’s financial health. A positive working capital (current assets greater than current liabilities) generally suggests that the company is in a sound financial position, capable of paying its debts as they come due. Conversely, a negative working capital (current liabilities greater than current assets) can be a sign of financial distress and may indicate that the company is at risk of bankruptcy or liquidity problems.

3. Managing Cash Flow

Working capital management is critical for ensuring that a company can meet its operational needs, especially in terms of cash flow. Companies need to have sufficient working capital to manage the day-to-day operations, including purchasing inventory, paying employees, and covering other operational expenses. Companies that manage their working capital effectively are better positioned to avoid cash shortages, invest in growth opportunities, and optimize their use of resources.

4. Flexibility in Business Operations

A company with a strong working capital position has more flexibility in its operations. It can take advantage of opportunities such as bulk purchasing, negotiating favorable payment terms with suppliers, or making timely investments in growth initiatives. A solid working capital cushion also allows a company to withstand unexpected financial shocks, such as a sudden drop in sales or a temporary increase in operating costs.

5. Creditworthiness and Borrowing Capacity

A company’s working capital is often assessed by creditors when determining its creditworthiness and ability to secure loans or lines of credit. Lenders typically look at a company’s current ratio (current assets divided by current liabilities) to gauge its ability to repay short-term obligations. A higher working capital suggests that a company is more likely to be able to meet its financial obligations, making it an attractive candidate for securing additional financing.

Learn how to calculate working capital with the following example:

Below are the extracts from James Ltd's balance sheet as at 31 December 2010:
Trade debtors $35,000
Trade creditors $20,000
Bank overdraft $10,000
Cash $80,000
Prepaid expenses $15,000
Accrued expenses $6,000
Proposed dividends $63,000
Opening stock $55,000
Closing stock $40,000
Calculate the working capital.

Solution:
Current Assets = Trade debtors + Cash + Prepaid expenses + Closing stock = 35,000 + 80,000 + 15,000 + 40,000 = $170,000
Current Liabilities = Trade creditors + Bank overdraft + Accrued expenses + Proposed dividends = 20,000 + 10,000 + 6,000 + 63,000 = $99,000

Working Capital = Current Assets - Current Liabilities = 170,000 - 99,000 = $71,000