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—like 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 financial health and efficiency of an organization.

Understanding Working Capital

Working capital is calculated from the assets and liabilities on a corporate balance sheet, focusing on immediate debts and the most liquid assets. Calculating working capital provides insight into a company's short-term liquidity and efficiency. A company with positive working capital generally has the potential to invest in growth and expansion. But if current assets don't exceed current liabilities, the company has negative working capital, and may face difficulties in growth, paying back creditors, or even avoiding bankruptcy.

The amount of working capital needed varies by industry, company size, and risk profile. Industries with longer production cycles require higher working capital due to slower inventory turnover. Alternatively, bigger retail companies interacting with numerous customers daily, can generate short-term funds quickly and often need lower working capital.

Working Capital Formula

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

Working Capital = Current Assets – Current Liabilities

Working capital is often expressed as a dollar figure. For example, if a company has $100,000 in current assets and $30,000 in current liabilities, it has $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 any reason.

A business can either have positive or negative working capital:

• Positive working capital: When this calculation is positive, it indicates that the company's current assets exceed its current liabilities, as in the above example. The company has more than enough resources to cover its short-term debt and some leftover cash if all current assets are liquidated to pay this debt.
• Negative working capital: When the calculation is negative, the company's current assets are insufficient to cover its current liabilities. This is a warning sign that the company has more short-term debt than short-term resources. It typically indicates poor short-term health, low liquidity, and potential problems in paying its debt obligations.
  

It's worth noting that while negative working capital isn't always bad and can depend on the specific business and its lifecycle stage, prolonged negative working capital can be problematic.

Components of Working Capital

Working capital consists of current assets and current liabilities. A company's balance sheet contains all working capital components, though it may not need all the elements discussed below. For example, a service company that doesn't carry inventory will simply not factor inventory into its working capital calculation.

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 liquidating all items below into cash.

• Cash and cash equivalents: All of the company's money on hand, including foreign investments and low-risk, short-term investments like money market accounts
• Inventory: Unsold goods, including raw materials, work-in-progress, and finished goods not yet sold
• Accounts receivable: Claims to cash for items sold on credit, net of any allowance for doubtful payments
• Notes receivable: Claims to cash from other agreements, usually documented with a signed agreement
• Prepaid expenses: The value for expenses paid in advance, which, while hard to liquidate, still carry short-term value
• Others: Any other short-term asset. For example, some companies may recognize a short-term deferred tax asset that reduces a future liability.

Current Liabilities

Current liabilities encompass all debts a company owes or will owe within the next 12 months. The overarching goal of working capital is to understand whether a company can cover all of these debts with the short-term assets it already has on hand.

• Accounts payable: Unpaid vendor invoices for supplies, raw materials, utilities, property taxes, rent, or any other operating expense owed. Credit terms on invoices are often net 30 days, capturing nearly all invoices.
• Wages payable: Unpaid salaries and wages for staff members. Depending on payroll timing, this typically accrues up to one month's worth of wages.
• Current portion of long-term debt: Short-term payments related to long-term debt. Only the upcoming 12 months' payments are included in working capital calculations.
• Accrued tax payable: Obligations to government bodies, including accruals for tax obligations not due for months but payable within the next 12 months
• Dividend payable: Authorized payments to shareholders. While a company may decline future dividend payments, it must fulfill obligations on already authorized dividends.
• Unearned revenue: Capital received in advance of completing work. If a company fails to complete a job, it may need to return this capital to the client.

Limitations of Working Capital

Working capital can be very insightful in determining a company's short-term health. However, some downsides to the calculation can make the metric sometimes misleading. Here are four limitations of working capital:

1. Changing values: Working capital is always changing. If a company is fully operating, several—if not most—current asset and current liability accounts will likely change. Therefore, by the time financial information is accumulated, it's likely that the company's working capital position has already changed.
2. Nature of assets: Working capital fails to consider the specific types of underlying accounts. For example, a company with positive working capital but whose current assets are entirely in accounts receivable may face liquidity issues if customers delay payments.
3. Asset devaluation: On a similar note, assets can quickly become devalued. This may happen due to factors beyond the company's control, such as customer bankruptcy affecting accounts receivable or inventory becoming obsolete or stolen. Physical cash is also at risk of theft, impacting working capital.
4. Unknown debt: Working capital calculations assume all debt obligations are accounted for. In fast-paced environments or during mergers, missed agreements or incorrectly processed invoices can skew the accuracy of working capital figures.
   

Special Considerations

Most major new projects, like expanding production or entering into new markets, often require an upfront investment, reducing immediate cash flow. Therefore, companies needing extra capital or using working capital inefficiently can boost cash flow by negotiating better terms with 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 isn't investing excess cash. Alternatively, it could mean a company fails to leverage the benefits of low-interest or no-interest loans.

Another financial metric, the quick ratio, measures the ratio of current assets to current liabilities. Unlike working capital, it uses different accounts in its calculation and reports the relationship as a percentage rather than a dollar amount.

Example of Working Capital

As of March 2024, Microsoft (MSFT) reported $147 billion of total current assets, which included cash, cash equivalents, short-term investments, accounts receivable, inventory, and other current assets.

The company also reported $118.5 billion of current liabilities, which comprise accounts payable, current portions of long-term debts, accrued compensation, short-term income taxes, short-term unearned revenue, and other current liabilities.

Therefore, as of March 2024, Microsoft's working capital metric was approximately $28.5 billion. If Microsoft were to liquidate all short-term assets and extinguish all short-term debts, it would have almost $30 billion remaining cash.

The Bottom Line

Working capital is critical to gauge a company's short-term health, liquidity, and operational efficiency. You calculate working capital by subtracting current liabilities from current assets, providing insight into a company's ability to meet its short-term obligations and fund ongoing operations. 

Positive working capital generally means a company has enough resources to pay its short-term debts and invest in growth and expansion. Conversely, negative working capital indicates potential cash flow problems, which might require creative financial solutions to meet obligations.

Working capital is a useful measure to track. Still, it's important to look at the types of assets and liabilities and the company's industry and business stage to get a more complete picture of its finances.