Working Capital Explained Simply
What is working capital?
Working capital, often referred to as net working capital, is the difference between a company's current assets and current liabilities.
Current assets are expected to be sold, used, or exhausted through standard business operations within one year. This includes assets like cash, accounts receivable, and inventory.
Current liabilities are bills due within the following year. This could include wages owed to workers, money owed to suppliers, and taxes owed to the government.
Both current assets and current liabilities are found on the balance sheet.
Why working capital is important
Working capital is a quick way to assess a company's liquidity, which is its ability to meet its short-term obligations. In other words, it serves as an indicator of a company's financial health.
If working capital is positive, it indicates that a company has sufficient resources to cover its short-term financial needs.
If working capital is negative, it indicates that a company may face financial difficulties.
How to calculate working capital
There are three ways to calculate working capital:
- The Simple Method
Current Assets - Current Liabilities
This is the most common and easiest to calculate.
- The Narrow Method
(Current Assets - Cash) - (Current Liabilities - Debt)
This method excludes cash and debt, which can be helpful when comparing companies with different capital structures.
- The Specific Method
Accounts Receivable + Inventory - Accounts Payable
Let's quickly review these terms before explaining why this method is helpful.
Accounts receivable are when a company has delivered a good or service, but not yet been paid for it.
Inventory is a company's products for sale, but have not yet been sold.
Accounts payable occur when a company receives goods or services for which it did not pay upfront but used credit.
Hence, the specific method for calculating working capital focuses on the cash conversion cycle of a business.
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