Working capital: formula, plus more

Working capital is a metric that indicates a business’s ability to cover its immediate operational expenses and meet short-term financial obligations (like short-term debts or upcoming tax payments).

Another way of looking at working capital is as a measure of how “liquid” a company is in the short term. You can calculate a company’s working capital by subtracting its current liabilities from its current assets. In other words, the working capital formula is simply:

Working Capital = Current Assets - Current Liabilities

This formula is sometimes referred to as net working capital, distinguishing it from other variations of the working capital formula, such as “operating” and “non-cash” working capital. In this guide, we’ll take you over:

• The four main components of working capital.
• 3 different types of working capital formulae and what each one can help you analyse.
• How to calculate working capital using these different formulae, with examples.
• The factors that can impact a company’s working capital.
• How to interpret working capital, and what it means for it to be positive or negative.

What are the four main components of working capital?

Although the working formula has two main components — assets and liabilities — they can be further broken down. Here’s what you need to know about the main two:

• Current assets are the resources your business owns that can either be turned into cash or consumed in the year. Examples include: inventory, cash and equivalents, checking and savings accounts, and liquid marketable securities like stocks, bonds, and mutual funds.
• Current liabilities are the expenses or debts your company owes that are due for payment within a year or one business cycle, whichever is less. Examples include: accounts payable, running expenses like rent and utilities, interest or principal payments on debt, short-term loans and long-term ones with upcoming due dates, and accrued income taxes.

While you can technically break down assets and liabilities into several subcomponents, the following ones are considered the main four components for working capital:

1. Cash and cash equivalents, which are the cash reserves for meeting operating expenses. This includes money a business has, such as in the bank, and assets that can be easily liquidated without losing much of their short-term value, like bonds or mutual funds.
   
   
2. Accounts receivable (AR), which is simply money a business is owed for any products or services they’ve delivered. Uncashed cheques, credit extended to other businesses, and open customer invoices are examples of accounts receivable.
   
   
3. Inventory, which is considered a short-term asset because businesses aim to quickly sell it to customers. Inventory refers to any tangible goods a business has on hand that are intended to be sold to customers.
   
   
4. Accounts payable (AP), which refers to the liabilities your business is expected to owe over the next year. AP includes wages payable to employees, upcoming taxes, supplier invoices, etc.

The first three components are current assets, while AP is a current liability. They’re considered the “main” four components because including them in your working capital calculation is sufficient to indicate a business’s financial health.

Alternative formulae for calculating working capital

The standard working capital formula — which subtracts current assets from liabilities — is one of several accounting formulae that give insights into a company’s financial health. Different variations of the working capital formula offer insights into other areas of a company’s performance. For example:

• Non-cash working capital (NCWC). This variation of the working capital formula subtracts current liabilities and cash from a company’s current assets, making the formula:
  
  Non-cash Working Capital = Current Assets – Cash – Current Liabilities.
  
  NCWC helps a business gauge its working capital that may convert to cash in the short term, such as accounts receivable, and evaluate the time it takes to convert non-cash assets into cash.
  
  
• Operating working capital (OWC). This formula measures the current assets and current liabilities used in a company’s daily operations. The calculation normally excludes cash and cash equivalent financial assets from the current assets, and debts or interest-bearing securities with debt-like terms from the current liabilities. The formula for OWC is:
  
  Operating Working Capital = Operating Current Assets - Operating Current Liabilities.
  
  Operating working capital gives analysts insight into the current assets and current liabilities needed to sustain a business’s operations.
  
  
• Net working capital (NWC). This term is often used interchangeably with “working capital,” in which case it uses the same formula of assets minus liabilities. However, some analysts use this modified formula for working capital:

Net Working Capital = (Current Assets - Cash - Short-term Investments) - ( Current Liabilities - Short-term Debt - Capital Leases - Dividends Payable).

Understanding working capital: high vs. low

Working capital indicates a company’s liquidity or ability to generate cash to meet its short-term financial obligations. You can also gauge a company’s liquidity by dividing its current assets by its current liabilities. This gives you the business’s working capital ratio.

Working Capital Ratio (WCR) = Current Assets / Current Liabilities.

A company’s working capital is high when its current assets are considerably higher than its liabilities, and low when its assets aren’t much higher than its liabilities. An organisation’s working capital can further be categorised as:

• Positive, when total current assets > total current liabilities. In this case, the company’s working capital ratio will be greater than 1. In general, a WCR between 1.5 and 2 is considered a good ratio for working capital.
• Negative, when total current assets < total current liabilities. In this case, the company’s working capital ratio is less than 1.
• Neutral, when the two are equal. In this case, the company’s working capital ratio is equal to one.

Let’s take a closer look at what each of these categories can indicate.

Positive working capital (WCR > 1)

Since working capital indicates liquidity, a company with a positive working capital has sufficient funds to meet its short-term financial commitments. In general, this indicates that the company is well-managed – i.e., it’s generating enough cash and hasn’t overstretched its financial obligations.

However, it’s important to keep in mind that working capital is just one metric for gauging a company’s underlying efficiencies – it doesn’t always tell the full story. In some circumstances, very high working capital can indicate inefficiencies or missed opportunities.

For example, let’s say a company prioritises maintaining liquidity, but it isn’t reinvesting its cash to grow or improve its operations. On paper, the company may have a high working capital, but in practice, it’s missing out on growth opportunities.

Most companies strive to maintain positive working capital, but that doesn’t mean they should use the metric as a north star. Focusing on achieving the highest working capital possible can be detrimental to a business’s long-term efficiency and growth.

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Negative working capital (WCR < 1)

Negative working capital means a company’s current assets aren’t enough to cover its short-term financial obligations. It can signal financial distress because:

• The business might have trouble paying its short-term obligations.
• The business might need to take on more short-term borrowing, or delay payments to its suppliers.

However, negative working capital doesn’t always indicate that a company is in financial trouble. For example, an organisation’s working capital might be temporarily negative if it makes one or more large purchases in a cycle – like buying equipment or investing in infrastructure. In such cases, the business is investing in its future.

Additionally, some businesses regularly have negative working capital. This is because specific businesses – like megacorporations that generate cash quickly and regularly or subscription-based businesses – can benefit from it.

Let’s break down why this works for major retail brands – like Tesco PLC, Target, and Walmart. These corporations have negative working capital because they usually sell inventory and collect cash at a faster rate than they pay their suppliers. This means, on paper, their total current assets are less than their total liabilities, even though fast turnover is actually a sign of efficiency.

Here’s what’s going on:

• The retailer takes cash upfront from customers, giving them a constant steady stream of cash. They don’t typically extend credit to their customers.
  
  
• They operate on a just-in-time inventory model, meaning they don’t maintain high inventory levels at any given moment.
  
  
• They don’t pay their suppliers immediately.

These corporations are effectively using supplier payments to fund their operations and reinvest in inventory before paying their own obligations. Doing so allows them to focus on generating more sales, contributing to their long-term growth.

Neutral working capital (WCR = 1)

Neutral working capital means a business’s current assets precisely cover its current liabilities. This indicates that the business can handle its short-term financial obligations, but it might not have enough funds left over for growth and reinvestment.

Can working capital change?

A company's working capital is assessed over a business cycle or 12-month period, meaning its working capital changes naturally over time because current liabilities and assets aren’t constants.

Here are some factors that can change a business’s working capital

• Changes in liability or asset status. Long-term liabilities can eventually become short-term; e.g., if your payback period for a loan is 10 years, it becomes a short-term liability in the ninth year. This change impacts a company’s working capital accordingly.
  
  However, it’s not just liabilities that can change from long-term to short-term; assets can too. For example, let’s say you purchased equipment required for your business’s daily operations, making it a long-term asset.
  
  Now, if you want to sell some of it off (maybe to purchase newer equipment), it becomes a current asset when you find a buyer. This change also affects your working capital.
  
  
• Market forces. The value of a business’s current assets – such as inventory – can be affected by market forces. For example, let’s say the purchase value of one item in your inventory is £400. Now, let’s say the product’s market price drops, and you have to mark each unit’s price down to £300. The loss in inventory value means you’ll now have less working capital.
  
  
• Cash injections. Cash investments can increase the value of a company’s current assets without impacting its short-term liabilities, raising its working capital overall. Funding, investment from company stakeholders, and working capital loans can all increase a business’s working capital.

Due to these various factors, it’s not uncommon for a business to alternate between periods of negative and positive working capital.

Summary: the working capital formula

Working capital is a useful metric for gauging a company’s liquidity, and specific variations of the formula (like non-cash working capital) offer distinct, granular insights. A positive working capital is generally a good sign for a business because it indicates the company has enough funds to meet its short-term needs.

Don’t forget that working capital is just one of many metrics that indicate a business’s underlying efficiencies and financials, though. If your working capital seems off – maybe it looks too high or too low – then it’s best to investigate the possible causes before drawing conclusions about your business’s financials and performance.

Additionally, viewing your working capital alongside other financial metrics, like your gearing ratio, can give you a clearer picture of your company’s overall financials.

Also read:

• Margin of safety: formula, and more
• Gearing ratio: what to know for your business
• What is operating profit?
• What is Capital Expenditure in Business?

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