Working Capital: Formula, Components, and Limitations

What Is Working Capital?

Working capital, also known as net working capital (NWC), is the difference between a company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories of raw materials and finished goods—and its current liabilities, such as accounts payable and debts. It's a commonly used measurement to gauge the short-term health of an organization.

Understanding Working Capital

Working capital estimates are derived from the array of assets and liabilities on a corporate balance sheet. By only looking at immediate debts and offsetting them with the most liquid of assets, a company can better understand what sort of liquidity it has in the near future.

Working capital is also a measure of a company’s operational efficiency and short-term financial health. If a company has substantial positive NWC, then it could have the potential to invest in expansion and grow the company. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors. It might even go bankrupt.

The amount of working capital a company has will typically depend on its industry. Some sectors that have longer production cycles may require higher working capital needs as they don't have the quick inventory turnover to generate cash on demand. Alternatively, retail companies that interact with thousands of customers a day can often raise short-term funds much faster and require lower working capital requirements.

Working Capital Formula

To calculate working capital, subtract a company's current liabilities from its current assets. Both figures can be found in the publicly disclosed financial statements for public companies, though this information may not be readily available for private companies.

Working Capital = Current Assets - Current Liabilities

Working capital is often stated as a dollar figure. For example, say a company has $100,000 of current assets and $30,000 of current liabilities. The company is therefore said to have $70,000 of working capital. This means the company has $70,000 at its disposal in the short term if it needs to raise money for a specific reason.

When a working capital calculation is positive, this means the company's current assets are greater than its current liabilities. The company has more than enough resources to cover its short-term debt, and there is residual cash should all current assets be liquidated to pay this debt.

When a working capital calculation is negative, this means the company's current assets are not enough to pay for all of its current liabilities. The company has more short-term debt than it has short-term resources. Negative working capital is an indicator of poor short-term health, low liquidity, and potential problems paying its debt obligations as they become due.

It is worth noting that negative working capital is not always a bad thing; it can be good or bad, depending on the specific business and its stage in its lifecycle; however, prolonged negative working capital can be problematic.

Components of Working Capital

All components of working capital can be found on a company's balance sheet, though a company may not have use for all elements of working capital discussed below. For example, a service company that does not carry inventory will simply not factor inventory into its working capital calculation.

Current assets listed include cash, accounts receivable, inventory, and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt that’s due within one year.

Current Assets

Current assets are economic benefits that the company expects to receive within the next 12 months. The company has a claim or right to receive the financial benefit, and calculating working capital poses the hypothetical situation of the company liquidating all items below into cash.

• Cash and Cash Equivalents: All of the money the company has on hand. This includes foreign currency and certain types of investments such as money market accounts with very low risk and very low investment term periods.
• Inventory: All of the unsold goods being stored. This includes raw materials purchased to manufacture, partially assembled inventory that is in process, and finished goods that have not yet been sold.
• Accounts Receivable: All of the claims to cash for inventory items sold on credit. This should be included net of any allowance for doubtful payments.
• Notes Receivable: All of the claims to cash for other agreements, often agreed to through a physically signed agreement.
• Prepaid Expenses: All of the value for expenses paid in advance. Though it may be difficult to liquidate these in the event of needing cash, they still carry short-term value and are included.
• Others: Any other short-term asset. An example is some companies may recognize a short-term deferred tax asset that reduces a future liability.

Current Liabilities

Current liabilities are simply all debts a company owes or will owe within the next twelve months. The overarching goal of working capital is to understand whether a company will be able to cover all of these debts with the short-term assets it already has on hand.

• Accounts Payable: All unpaid invoices to vendors for supplies, raw materials, utilities, property taxes, rent, or any other operating expense owed to an outside third party. Credit terms on invoices are often net 30 days, so essentially all invoices are captured here.
• Wages Payable: All unpaid accrued salary and wages for staff members. Depending on the timing of the company's payroll, this may only accrue up to one month's worth of wages (if the company only issues one paycheck per month). Otherwise, these liabilities are very short-term in nature.
• Current Portion of Long-Term Debt: All short-term payments related to long-term debt. Imagine a company finances its warehouse and owes monthly debt payments on the 10-year debt. The next 12 months of payments are considered short-term debt, while the remaining 9 years of payments are long-term debt. Only 12 months are included when calculating working capital.
• Accrued Tax Payable: All obligations to government bodies. These may be accruals for tax obligations for filings not due for months; however, these accruals are usually always short-term (due within the next 12 months) in nature.
• Dividend Payable: All authorized payments to shareholders. A company may decide to decline future dividend payments but must fulfill obligations on already authorized dividends.
• Unearned Revenue: All capital received in advance of having completed work. Should the company fail to complete the job, it may be forced to return capital back to the client.

Limitations of Working Capital

Working capital can be very insightful to determine a company's short-term health. However, there are some downsides to the calculation that make the metric sometimes misleading.

First, working capital is always changing. If a company is fully operating, it's likely that several—if not most—current asset and current liability accounts will change. Therefore, by the time financial information is accumulated, it's likely that the working capital position of the company has already changed.

Working capital fails to consider the specific types of underlying accounts. For example, imagine a company whose current assets are 100% in accounts receivable. Though the company may have positive working capital, its financial health depends on whether its customers will pay and whether the business can come up with short-term cash.

On a similar note, assets can quickly become devalued. Accounts receivable balances may lose value if a top customer files for bankruptcy. Inventory is at-risk of obsolescence or theft. Physical cash is also at risk of theft. Therefore, a company's working capital may change simply based on forces outside of its control.

Last, working capital assumes all debt obligations are known. In mergers or very fast-paced companies, agreements can be missed or invoices can be processed incorrectly. Working capital relies heavily on correct accounting practices, especially surrounding internal control and safeguarding of assets.

Special Considerations

Most major new projects, such as an expansion in production or into new markets, require an upfront investment. This reduces immediate cash flow. Therefore, companies that are using working capital inefficiently or need extra capital upfront can boost cash flow by squeezing suppliers and customers.

On the other hand, high working capital isn’t always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash. Alternatively, it could mean a company is failing to take advantage of low-interest or no-interest loans; instead of borrowing money at a low cost of capital, the company is burning 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 accounts in its formula, it reports the relationship as a percentage as opposed to a dollar amount.

Example of Working Capital

At the end of 2021, Microsoft (MSFT) reported $174.2 billion of current assets. This included cash, cash equivalents, short-term investments, accounts receivable, inventory, and other current assets.

The company also reported $77.5 billion of current liabilities comprised of accounts payable, current portions of long-term debts, accrued compensation, short-term income taxes, short-term unearned revenue, and other current liabilities.

Therefore, at the end of 2021, Microsoft's working capital metric was $96.7 billion. If Microsoft were to liquidate all short-term assets and extinguish all short-term debts, it would have almost $100 billion of cash remaining on hand.

Another way to review this example is by comparing 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 would be able to pay every single current debt twice and still have money left over.

The Bottom Line

Working capital is used to gauge the short-term health of a company by measuring its current assets to its current liabilities, reflecting how well it can pay off debts and fund its current operations without taking on external funding.