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How is Working Capital Defined and Why Is It Important?

by Brett Backues on August 30, 2016
When it comes to using accounting information, there are several different ways that decision makers can work with numbers to determine what actions they should take in business. The ratios and key indicators they use also tell them how health the business is and if they need to take any actions to improve their current situation. One of the key indicators that is often used in business is working capital.

What is Working Capital?

Working capital is defined as the capital that a business has to meet its day-to-day operations and requirements. The equation for working capital is quite simple. It is calculated as the current assets less he current liabilities of the business.

Current assets are all of those assets that the company is able to turn into cash fairly easily. In general, current assets should include anything that can, or is expected to be, turned into cash within a year or business cycle. These assets include the cash accounts of a company, accounts receivable that are due within a year, prepaid expenses, easily liquidated investments, and inventory.

Current liabilities are all liabilities that are due to be paid by the company within a year or business cycle. This includes the amounts in accounts payable that is due to be paid within a year, principal from notes and debt that has to be paid within the year, and other current liabilities like income and payroll taxes payable.

The theory is that the working capital amount takes all of the assets that the company is going to get within the year, and it subtracts out all of the liabilities that will have to be paid with those assets. The final working capital number is the dollar value of assets that will be left over for the company once all of the liabilities for the year have been paid. This number can be extremely useful to businesses.

What is Working Capital Used to Determine

Working capital is a measurement used by accountants and business leaders to determine if they have enough assets to cover the liabilities related to their day-to-day operations. If the working capital amount is negative, this indicates that in the current time period there are not enough assets in the company to meet the liabilities. This is called negative working capital and can be an indicator of liquidity issues at the company, and also a possible indicator of impending bankruptcy. 

When working capital is positive, this means that the company has more than enough assets to cover its liabilities. This positive ratio is a good thing for companies to have, but it could also indicate that the company should be investing that extra capital in the business (assets that are not included in the working capital equation) instead of holding it in liquid assets. This would be the equivalent of you putting money under your mattress instead of putting it in a money market account or retirement account. The same rules apply to businesses. If they are holding money in cash accounts in excess, then they are missing out on additional revenue available by investing the cash back in the business.

Another Way to Look at Working Capital: Working Capital Ratio

Another way to view the working capital of a company is by using the working capital ratio (sometimes also called the current ratio). This ratio is just current assets divided by current liabilities. Just like the working capital equation, the working capital ratio shows decision makers where they stand on meeting the day-to-day obligations of their business.

If the working capital ratio yields a quotient of 1.0 or lower, the company has a negative working capital ratio. This means that when you did the calculation your current assets were lower than your current liabilities. Just like in the working capital equation, this means that you could be facing tough times meeting all of your liabilities with your current assets.

If the working capital ratio is higher than 1.0, but less than 2.0, then your company is said to have a good positive ratio. This means that your company has a healthy enough amount of current assets to meet its current liabilities, but it does not have so many current assets hat it is taking away from possible revenue streams in the future.
If the working capital ratio is higher than 2.0, the company needs to consider reinvesting some of its liquid assets and cash into the company. This could also indicate that the company has far too much inventory on hand.

The Quick Ratio

The quick ratio, or acid test ratio, is another liquidity ratio that is a variation of the working capital ratio (current ratio). The main difference between the quick ratio and current ratio is that is that the quick ratio excludes inventory from current assets.

Why would a ratio want to exclude inventory from a liquidity ratio? Well, when it comes down to it, inventory might be sold, but it will probably not turn into cash right after it is sold. Not only that, but if a company has slow moving inventory and they use a current ratio, they will be given a ratio that is skewed in the favor of assets, giving them an unrealistic expectation of being able to meet their current liabilities. By excluding inventory from the current ratio, you will be using a more conservative estimate of your ability to meet your current liabilities and staying in business.

These liquidity equations and ratios are not something that companies should just skip over. They are an extremely easy and low-cost way to determine if your company will be able to meet its obligations using only current assets. If you find that you have negative working capital or a current ratio below one, you can change the way that you are doing things in order to make your business solvent again. On the other hand, if you find that you have a very high amount of working capital and a current ratio greater than 2.0, you might want to consider investing that excess cash back into your business. Either way, doing these calculations is quick, and it yields you a whole lot of useful information.
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