Working Capital: Formula, Components and Limitations (2023)

What is working capital?

Working capital, also known as net working capital (NWC), is the difference between a company's working capitalcurrent assets– such as cash, customer receivables/unpaid invoices and inventories of raw materials and finished goods – and theircurrent liabilitiessuch as liabilities and debts. It is a metric commonly used to measure an organization's short-term health.

Understand working capital

Working capital estimates are derived from a company's pool of assets and liabilities.balance sheet. By only looking at immediate debt and offsetting it against the most liquid assets, a company can better understand what kind of liquidity it has in the near future.

Working capital is also a measure of a company's performance.operational efficiencyand short-term financial health. If a company has a significantly positive NWC, it may have the potential to invest in expansion and grow the business. If a company's current assets don't exceed its short-term liabilities, it may have trouble growing or paying off creditors. You could even go bankrupt.

A company's level of working capital generally depends on its industry. Some industries with longer production cycles may require higher working capital needs because they don't have the fast inventory turns to generate cash on demand. Alternatively, retail businesses that interact with thousands of customers every day can often raise short-term funds much more quickly and require less working capital.

Working-Capital-Formel

ACalculate working capital, subtract a company's current liabilities from its current assets. Both figures can be found in publicly available financial statements of listed companies, although this information may not be readily available for private companies.

Working capital = current assets - current liabilities

Working capital is often expressed in dollars. For example, let's say a company has $100,000 in current assets and $30,000 in current liabilities. Therefore, the company is said to have working capital of $70,000. That means the company has $70,000 on hand in the short-term if it needs to raise money for some reason.

When a working capital calculation is positive, it means that the company's current assets are greater than its current liabilities. The company has more than enough resources to pay its debts in the short term and there is residual liquidity should all current assets be liquidated to pay off those debts.

When a working capital calculation is negative, it means the company has insufficient working capital to pay all of its current liabilities. The company has more current debt than current resources. Negative working capital is an indicator of short-term illness, low liquidity, and potential difficulty in paying your debts when they come due.

Working Capital Components

All of the components of working capital can be found on a company's balance sheet, although a company may not be able to use all of the working capital items discussed below. For example, a utility company that doesn't keep inventory simply won't include inventory in its working capital calculation.

Current assets listed include cash, accounts receivable, inventory and other assets that are expected to be settled or converted to cash in less than one year. Current liabilities include trade payables, salaries, taxes payable and the current portion of non-current liabilities that are due within one year.

current assets

Current assets are the economic benefits that the company anticipates over the next 12 months. The company has a claim or right to receive economic benefits and the working capital calculation assumes that the company will settle all of the items below in cash.

• Cash and cash equivalents:All the money available to the company. These include foreign currencies and certain forms of investment, such as B. Money market accounts with very low risk and very short investment periods.
• Invent:All unsold goods that are in storage. This includes raw materials purchased for manufacturing, partially assembled inventory that is in process, and finished goods that have not yet been sold.
• accounts obtainable:All cash claims for inventory items sold on credit. This should be included with no provision for doubtful payments.
• Documents to collect:All monetary claims for other agreements, often settled by a physically signed agreement.
• Prepaid Expenses:The total value of the prepaid expenses. While they can be difficult to liquidate when you need cash, they still have short-term value and are included.
• Others:All other current assets. An example is that some companies recognize a current deferred tax asset that reduces a future liability.

current liabilities

Current liabilities are simply any debt that a company owes or has to pay off in the next 12 months. The overall goal of working capital is to understand whether a company will be able to cover all of that debt with the current assets already available.

• Accounts Payable:Any unpaid bills to suppliers for supplies, raw materials, utilities, property taxes, rent or other operating expenses owed to an external third party. Invoice credit terms are typically net 30 days, so essentially all invoices are captured here.
• Salaries to be paid:All unpaid earned wages and salaries of employees. Depending on the timing of the company's payroll, this may only accrue up to one month's wages (if the company only issues one paycheck per month). Otherwise, these liabilities are of a very short-term nature.
• Current portion of non-current liabilities:All short-term payments related to long-term debt. Imagine a company finances its inventory and owes monthly debt for 10 years. Payments for the next 12 months are considered current debt, while payments for the remaining 9 years are considered long-term debt. Only 12 months are taken into account when calculating working capital.
• Accumulated tax payable:All obligations to government agencies. They can be accruals of tax obligations for late filings in months. However, these accumulations are generally always of a short-term nature (due within the next 12 months).
• Dividend to be paid:All authorized payments to authorized shareholders. A company may elect to decline future dividend payments, but must honor obligations for dividends already approved.
• unearned income:Received all capital before the work is completed. If the company does not complete the work, it may be forced to return the capital to the customer.

Working Capital Restrictions

Working capital can be very insightful when it comes to determining a company's near-term health. However, there are some drawbacks to the calculation that sometimes make the metric misleading.

First, working capital is constantly changing. When a company is fully operational, it is likely that some, if not most, of the current asset and liability accounts will change. Therefore, it is likely that by the time the financial information accumulates, the position of the company's working capital has already changed.

Working capital does not take into account the specific types of underlying accounts. For example, imagine a company whose current assets are 100% accounts receivable. Although the company may have positive working capital, its financial health depends on its customers paying and the company's ability to raise money in the short term.

Similarly, assets can lose value quickly. Receivables can lose value if a major customer files for bankruptcy. Inventory is at riskobsolescenceor robbery. Physical cash is also at risk of theft. Therefore, a company's working capital can change simply due to forces beyond its control.

Finally, working capital assumes that all debt obligations are known. In the case of mergers or very fast-moving companies, deals can be lost or invoices processed incorrectly. Working capital relies heavily on sound accounting practices, particularly with regard to internal control and asset protection.

Special considerations

Most large new projects, such as expanding production or opening up new markets, require an initial investment. This reduces the immediate cash flow. Therefore, companies that use working capital inefficiently or need additional upfront capital can increase cash flow by putting pressure on suppliers and customers.

On the other hand, high working capital is not always good. It could indicate that the company is overstocking or not investing its excess cash. Alternatively, it could mean that a company is not taking advantage of low interest rates orinterest free loans; Instead of borrowing money at a low cost of capital, the company burns its own resources.

A similar financial metric called the quick ratio measures the ratio of current assets to current liabilities. In addition to using different counts in his formula, he gives the ratio as a percentage rather than a dollar amount.

Working capital example

At the end of 2021, Microsoft (MSFT) reported working capital of $174.2 billion.These included cash, cash equivalents, short-term investments, trade accounts receivable, inventories and other short-term assets.

The company also reported current liabilities of $77.5 billion, which consisted of trade payables, the current portion of long-term debt, accrued compensation, current income taxes, current unearned income and other current liabilities.

Thus, at the end of 2021, Microsoft's working capital ratio was $96.7 billion. If Microsoft liquidated all of its current assets and paid off all of its current debt, it would have nearly $100 billion in cash on hand.

Another way to verify this example is to compare working capital to current assets or current liabilities. For example, Microsoft's working capital of $96.7 billion is greater than its current liabilities. Therefore, the company could pay the ongoing debt twice and still have money left over.