Key Takeaways
- Working capital is a financial metric that measures the difference between a business’s current assets and liabilities.
- The working capital formula calls for subtracting current liabilities on a company’s balance sheet from current assets: working capital = current assets – current liabilities.
- Positive working capital means a business has sufficient cash, accounts receivable, and other liquid assets to meet its short-term obligations.
This covers the ins and outs of working capital, including what it means for companies and investors, and how much is needed. The article also explains the limitations of working capital and how it affects cash flow.
Here is what is working capital – how to calculate it and why it is important.
What is Working Capital?
Working capital is a financial metric that measures the difference between a business’s current assets and liabilities.
Generally, a company that maintains positive working capital is better able to endure financial woes. Once it meets short-term obligations, it also will typically have more flexibility to invest in growth.
What are the Components of Working Capital?
In addition to cash, “current assets” include those that can be converted into cash within a year. Specifically, that means marketable securities, short-term investments, and accounts receivable. It can also mean notes receivable, inventory, prepaid expenses, and advance payments on future purchases.
“Current liabilities” include, but are not limited to, accrued expenses, accounts payable, notes payable, and payroll. They can also include wages, taxes, deferred revenue, and interest owed.
Working Capital vs Fixed Assets
Working capital includes liquid current assets.
Because they are illiquid, fixed assets are not included in working capital. Fixed assets can include tangible assets such as equipment, facilities, and real estate. They can also include intangibles such as trademarks and patents.
How Do You Calculate Working Capital?
The working capital formula calls for subtracting current liabilities on a company’s balance sheet from current assets: working capital = current assets – current liabilities.
For example, say a company has $220,000 in current assets and $130,000 in liabilities. This means it has $90,000 in working capital.
What is the Working Capital Ratio?
Also known as current ratio, working capital ratio is a measure of a business’s ability to meet short-term obligations.
A company that has a ratio of under 1 means it is generating insufficient cash to cover coming-year debts. A company that has a working capital ratio of between 1.2 and 2.0, though, generally indicates an effective use of assets. However, a ratio of more than 2.0 means the company is likely not making optimal use of said assets.
What is the Difference Between Quick Ratio and Working Capital Ratio?
Current ratio — or working capital ratio — and quick ratio are tools for measuring liquidity and the ability to cover short-term debts.
The difference here is that the quick ratio only includes the company’s most liquid assets. These assets are accounts receivable, marketable securities, and cash and equivalents, excluding inventory. Meanwhile, the current ratio includes all current assets.
Investors monitor both metrics to assess a company’s financial health. A balanced quick ratio, typically around 1 or higher, suggests swift debt coverage. This means a company can cover its short-term liabilities with its most liquid assets, without relying on selling inventory.
A healthy working capital ratio (current ratio) indicates overall short-term asset strength.
What is Positive vs Negative Working Capital?
Positive working capital means a business has sufficient cash, accounts receivable, and other liquid assets to meet its short-term obligations.
On the other hand, a company with insufficient working capital to cover short-term obligations has negative working capital. Such a company may have trouble growing or even staying in business.
What are the Limitations of Working Capital?
While sufficient working capital allows a business to withstand revenue fluctuations, there are still limitations.
For one thing, if a business is fully operational, working capital is constantly changing. It is also likely that a number of, if not all, current liabilities will change. Thus, by the time financial data is recorded, the company’s working capital position will likely have changed.
Also, working capital does not factor in specific types of underlying accounts. For example, say a company has all its current assets in accounts receivable. It does have positive working capital. However, the company’s financial well-being hinges on whether companies will pay. It also depends on whether the business can find short-term cash.
Further, assets can suddenly and swiftly become devalued. This can happen when a top client files for bankruptcy, for example, or when physical cash is stolen.
Finally, not all debt obligations are always known. This can happen during mergers, for example, or with very fast-paced businesses. Invoices may be incorrectly processed, or accounting practices may be incorrect.
How Does Working Capital Affect Cash Flow?
Cash flow, summarized in the company’s cash flow statement, measures the amount of money a business produces or consumes in a given period.
A business’s cash flow impacts the company’s working capital coffers. A drop in revenue will usually result in negative cash flow. If that happens, the company will draw down working capital.
What Does Working Capital Tell You About a Company’s Standing?
Companies need working capital to fund operations and pay for short-term obligations, regardless of cash flow issues.
Such capital is also commonly used to fund business growth without taking on debt. If borrowing does become necessary, having positive working capital can help secure a loan.
All told, how much working capital a company has reveals how much cash the business has on hand. It also reveals whether the business has enough working capital to cover liabilities, in addition to contingencies and growth opportunities. Such knowledge is useful for investors and lenders.
How to Invest in Venture Capital
Working capital relates to investing in early-stage companies through venture capital funds. These funds contain pooled investment capital that is managed for investors who seek private equity in startups. Such new businesses have potential for strong growth.
The leading alternative investment platform Yieldstreet, on which $4 billion has been invested to date, offers highly vetted opportunities for investment in early-stage businesses with venture capital funds.
Yieldstreet, which offers the broadest selection of alternative assets available, has a venture capital program. The opportunities offer retail investors exposure to private companies that are disrupting sectors or establishing entirely new ones. It is during these early phases that companies tend to experience fast growth as commercialization gets going in earnest.
Taking positions in private markets also serves another crucial purpose – portfolio diversification. Building a modern portfolio with a mix of asset types is fundamental to overall risk mitigation.
