So, what is working capital? The strict definition is current assets minus current liabilities. To an accountant, it tells how much cash is tied up in the business through receivables and inventories and also how much cash is going to be needed to pay off short term debts in the coming 12 month period.
Why is it important? Well, if a company’s current assets are less than current liabilities, a company has a working capital deficiency, also called a working capital deficit. This means it cannot pay off its short term debts. Its operation liquidity is low and the company is thus in danger of going bust. Positive working capital is needed for a firm to be able to continue its operations, not only by be able to pay off short term debt but also cover unexpected expenses.
When calculating Working Capital an accountant would typically look at the following three accounts
- accounts receivable (asset)
- inventory (asset)
- accounts payable (liability)
With what we know from before we would then get the following (simplified) formula as definition of Working Capital:
accounts receivable + inventory - accounts payable
The formal calculation of Working Capital depends on the situation. When evaluating a firm (calculating company value) WC is calculated as follows:
The so called Working Capital ratio (current ratio) is calculated as current assets divided by current liabilities. Your current ratio will give you an idea if you have enough working capital to sustain your business and meet your short-term financial obligations.
What’s a good ratio? As with all financial metrics, the opinion on what an ideal ratio is varies. Some say 2, more conservative say 3. The higher the ration, the better off (short term) the operating liquidity situation of your company.
Too high ratio points to poor use of the company’s capital as it would generate more revenue being put to work. The closer the ratio is to 1, the more sensitive your company becomes to unexpected expenses.