Working capital : 4 things to know
Few indicators can give as instant a snapshot of a company’s short-term financial health than its working capital. Knowing how to calculate and interpret the working capital of a business as part of financial statement analysis can be extremely useful and can provide insights for investors and business owners alike. It can be useful during both internal and external audits. Let’s take a closer look at this key performance indicator.
What is working capital?
In the simplest of terms, working capital, often referred to as net working capital, represents the difference between the current assets and the current liabilities of a company. This ratio indicates whether the company has sufficient liquid assets to cover all the bills due over the course of the coming year.
When a company’s current assets are greater than its current liabilities, the business is said to have positive working capital. In practical terms, this means it has money left to be spent on day-to-day operations or to invest in growth. Although having positive working capital is a good indication of performance, excessively high working capital might also indicate that the company is not optimising its operations.
When the value of a company’s current assets is less than the value of its current liabilities, this indicates that the company has negative working capital. This may mean that the company could face operational difficulties in the coming twelve months although, as we shall see shortly, this is not always the case. A company with negative working capital may need to look to loans in order to finance its liabilities and may face difficulties with paying suppliers or employees on time which may in turn trigger lower credit ratings for the company.
When current assets are equal to current liabilities, the company is said to have reached break-even point, but will need to generate positive working capital in order to grow.
How is working capital calculated?
A company’s working capital is calculated by deducting its current liabilities from its current assets. In other words:
Working capital = current assets – current liabilities.
A company’s working capital is usually expressed as an amount of money.
For example, if a company has £100,000 in current assets and £65,000 in current liabilities, its working capital is calculated as follows:
£100,000 - £65,000 = £35,000.
This company is said to have £35,000 working capital.
A company’s current assets are those assets that could be converted to cash within the coming year. The most common types of current assets are cash, cash equivalents, accounts receivable (i.e. unpaid invoices which are due within the year), inventory likely to be sold within the year, and short-term investments.
“Accounts receivable” represents all the money due to the company for the goods and services it has sold or delivered but which have not yet been paid for. They are considered as current assets as long as it is reasonably expected for them to be settled within the coming year. An account which is considered not to be receivable may be written off as a bad debt, in which case it is no longer included in the current assets.
These are essentially assets which could be liquidated if necessary in the short term to help cover the company’s outstanding liabilities.
A company’s current liabilities are defined as its financial obligations which are due within the coming year. Examples of current liabilities include accounts payable, short-term debts, accrued expenses, taxes, and dividends payable.
“Accounts payable” refers to the company’s debts to its creditors and suppliers. When a company purchases something, it may typically have 30 or 45 days to settle the invoice. This would be listed under “accounts payable” in the company’s balance sheet. This gives the company time to either sell the item on or use it to generate revenue before it settles the invoice.
In other words, it refers to all the short-term debts that the company will be obligated to cover within the next twelve months.
Taxes are another major element of corporate current liabilities in most countries, and include income taxes, corporation taxes, VAT, and payroll taxes withheld from employees but not yet passed onto the government.
Is positive working capital always good?
Although positive working capital is generally a good indicator of a company’s short-term financial health, having excessive positive working capital may indicate that the company is not optimising its performance. Sitting on high amounts of working capital rather than reinvesting it in the company or channelling it into new growth may suggest that the company is not maximising its potential, and may perhaps be indicative of management difficulties within the company.
Is negative working capital always bad?
Although negative working capital may indicate that a company will struggle to cover its liabilities in the coming year, this need not necessarily be the case. Companies can generally improve their working capital by selling more of their product or services.
Depending on the type of business, negative working capital need not necessarily spell disaster. Businesses that general cash very quickly, such as fast-food stores and retailers, often have high stock turnover and receive cash payments rather than having extended payment schedules. Their cash flow is therefore high, and any negative working capital can quickly be compensated for.
A company which is based on the supply of expensive equipment, in contrast, may be obliged to offer lengthy payment terms, and will, therefore, be less able to improve their working capital in the short term.
A company’s working capital is calculated by deducting its current liabilities from its current assets. A positive working capital generally indicates that the company is in good financial health and can cover all its debts over the coming year. A negative working capital usually, but not necessarily, indicates that the company will need to generate more cash or take out further loans in order to cover its debts over the next twelve months.
Calculating a company’s working capital and comparing it to its competitors can give insight into the company’s likely financial health at any given moment in time. Mooncard can help you accurately calculate your company’s working capital, freeing you up to focus on how to maximise your performance. Find out more by booking a no-obligation demonstration today.