Working Capital

In This Article

• Working capital is calculated as current assets minus current liabilities, and measures a company’s near–term liquidity from a risk perspective.
• Analyzing the working capital trends of a company relative to historical periods and comparing them to industry benchmarks offers practical insights into its near–term financial state and operating efficiency.
• A positive working capital balance implies that there is sufficient liquid current assets to meet the burden of its current obligations, whereas a negative balance indicates there is risk in missing to meet its short-term liabilities.
• A high working capital balance provides a margin of safety (or “cushion) for the company to handle short-term financial obligations.
• The caveat is an excessively high working capital can stem from the inefficient use of assets, such as holding too much inventory on hand for too long or an ineffective system for the collection of receivables from customers that paid on credit, as opposed to cash.
• A negative working capital balance could potentially serve a signal for the necessity an urgent injection of external financing or initiatives to improve cash flow management.

How to Calculate Working Capital

In financial accounting, working capital is a specific subset of balance sheet items, and calculated by subtracting current liabilities from current assets.

Working capital is a fundamental part of financial management, which is directly tied to a company’s operational efficiency and long-term viability.

In simple terms, working capital is the net difference between a company’s current assets and current liabilities, and reflects its liquidity, or the cash on hand under a hypothetical liquidation.

Therefore, the working capital metric measures a company’s near-term liquidity by comparing its current assets to its current liabilities.

• Current Assets ➝ Current assets are those that can be converted into cash within one year (<12 months), such as cash and cash equivalents, marketable securities, short-term investments, accounts receivable, inventory, and prepaid expenses.
• Current Liabilities ➝ Current liabilities are obligations that are due within one year (<12 months), like accounts payable, short-term loans, the current portion of long-term debt, and accrued expenses.

The working capital line items—or operating assets and operating liabilities—are used to fund a company’s day-to-day operations and fulfill short-term obligations.

By comparing the current assets of a particular company to its current liabilities, the working capital metric is comparing the resources with positive economic value to its short-term obligations.

The management of capital is critical to the business cycle, including the acquisition of raw materials, production of goods or services, sales on credit (i.e. customer paid using credit, rather than cash), and collection of the owed payment in cash.

In the event of any unexpected occurrence that disrupts the workflow cycle, such as the unanticipated need to produce more inventory in excess of the originally planned amount—or the delay in the issuance of an owed payment of invoices beyond 30 days—an increase in working capital can be mandatory to sustain its operating activities.

Working Capital Formula

The formula to calculate working capital—at its simplest—is equal to the difference between current assets and current liabilities.

The current assets and current liabilities are each recorded on the balance sheet of a company.

• Current Assets ➝ Current assets are converted into cash within a year (<12 months).
• Current Liabilities ➝ Current liabilities are near-term obligations due within a year (<12 months).

What are the Components of Working Capital?

Working capital is composed of current assets and current liabilities.

The assets and liabilities are classified as “current” because they are expected to be converted into cash (for assets) or paid (for liabilities) within a company’s normal operating cycle, which is typically one year.

The most common examples of each type of current asset and current liability are defined here:

What are Examples of Current Assets?

• Cash and Cash Equivalents ➝ The most liquid assets, including physical currency, checking account balances, and short-term investments that can be easily converted into cash within 90 days, such as treasury bills or money market funds.
• Marketable Securities ➝ Investments in highly-liquid securities that can be readily bought or sold on public exchanges, such as stocks and bonds. They are considered current assets if the company intends to sell them within a year.
• Accounts Receivable (A/R) ➝ The payments owed to a company by its customers for goods or services purchased on credit. It’s considered a current asset because it’s expected to be collected within a year.
• Inventory ➝ Raw materials, work-in-progress (WIP), and finished goods that a company holds for sale. It’s a current asset because it’s expected to be sold and converted into cash within a year.
• Prepaid Expenses ➝ Payments made in advance for goods or services that will be received in the future, such as prepaid rent or insurance premiums. The portion that will be used within a year is considered a current asset.

What are Examples of Current Liabilities?

• Accounts Payable (AP) ➝ Unmet payment obligations that a company owes to its suppliers for goods or services purchased on credit. Payables are recognized as a current liability because the invoice is expected to be paid within a year.
• Accrued Expenses ➝ Expenses that have been incurred but not yet paid, such as salaries, interest, or taxes. Like the accounts payable line item, accrued expenses are considered current liabilities because these obligations are due within a year.
• Deferred Revenue ➝ The deferred revenue, or “unearned revenue”, is funds received by a company in advance for goods or services that have not yet been provided. The portion that will be earned within a year is considered a current liability.
• Short-Term Debt ➝ Any borrowing that is due within a year, such as a short-term loan or the current portion of long-term debt (<12 months).
• Current Portion of Long-Term Debt ➝ The portion of a company’s long-term debt, such as bonds or loans, that is due within the next year. The line item is separated from the long-term portion and classified as a current liability.

How to Calculate Working Capital Ratio

The working capital ratio is a method of analyzing the financial state of a company by measuring its current assets as a proportion of its current liabilities, rather than as an integer.

The formula to calculate the working capital ratio divides a company’s current assets by its current liabilities.

Where:

• Positive Working Capital Ratio ➝ Therefore, if a company exhibits a working capital ratio in excess of 1.0x, that implies net positive working capital.
• Negative Working Capital Ratio ➝ Conversely, if the working capital ratio is below 1.0x, the company has net negative working capital.

Working Capital Example

For an illustrative example, here is the balance sheet of Noodles & Company, a fast-casual restaurant chain. Noodles & Company, per its latest financial filing, recorded $21.8 million in current assets and $38.4 million in current liabilities, for a negative working capital balance of -$16.6 million.

• Working Capital = $21.8 million — $38.4 million = ($16.6 million)

How to Analyze Working Capital

One common financial ratio used to measure working capital is the current ratio, a metric designed to provide a measure of a company’s liquidity risk.

The current ratio is calculated by dividing a company’s current assets by its current liabilities.

The current ratio is of limited utility without context, but a general rule of thumb is that a current ratio of > 1.0x implies a company is more liquid because it has liquid assets that can presumably be converted into cash and will more than cover the upcoming short-term liabilities.

The quick ratio—or “acid test ratio”—is a closely related metric that isolates only the most liquid assets such as cash and receivables to gauge liquidity risk.

Why? The benefit of neglecting inventory and other non-current assets is that liquidating inventory may not be simple or desirable, so the quick ratio ignores those as a source of short-term liquidity.

How to Understand Change in Working Capital (NWC)

When it comes to modeling working capital, the primary modeling challenge is to determine the operating drivers that need to be attached to each working capital line item.

The major working capital items are fundamentally tied to the core operating performance, and forecasting working capital is simply a process of mechanically linking these relationships on the three financial statements (e.g. income statement, cash flow statement, and balance sheet).

The balance sheet organizes assets and liabilities in order of liquidity (i.e. current vs long-term), making it very easy to identify and calculate working capital (current assets less current liabilities).

Meanwhile, the cash flow statement organizes cash flows based on whether items are operating, investing, or financing activities, as you can see from Noodles & Co.’s cash flow statement below:

How to Reconcile Working Capital on Cash Flow Statement

The balance sheet organizes items based on liquidity, but the cash flow statement organizes items based on their nature.

The three sections of a cash flow statement under the indirect method are as follows.

• Cash from Operating Activities (CFO) ➝ Net Income, Depreciation, Amortization, Change in Working Capital
• Cash from Investing Activities (CFI) ➝ Capital Expenditure (Capex), Sale of PP&E
• Cash from Financing Activities (CFF) ➝ Debt Issuance, Equity Issuance

As it so happens, most current assets and liabilities are related to operating activities[1] (inventory, accounts receivable, accounts payable, accrued expenses, etc.) and are thus primarily clustered in the operating activities section of the cash flow statement under a section called “changes in operating assets and liabilities.”

Because most of the working capital items are clustered in operating activities, finance professionals generally refer to the “changes in operating assets and liabilities” section of the cash flow statement as the “changes in working capital” section.

However, this can be confusing since not all current assets and liabilities are tied to operations. For example, items such as marketable securities and short-term debt are not tied to operations and are included in investing and financing activities instead (although in the above example, Noodles & Co happened to not have any marketable securities or short-term debt).

Working Capital vs. Net Working Capital (NWC): What is the Difference?

Adding to the confusion is that the “changes in operating activities and liabilities”, often called the “changes in working capital” section of the cash flow statement commingles both current and long-term operating assets and liabilities.

The purpose of the section is to identify the cash impact of all assets and liabilities tied to operations, not just current assets and liabilities.

For example, Noodles & Co classifies deferred rent as a long-term liability on the balance sheet and as an operating liability on the cash flow statement[2]. It is thus not included in the calculation of working capital, but it is included in the “changes in operating activities and liabilities” section (which we now know people often also refer to, confusingly, as “changes to working capital”).

What is a Good Working Capital?

Now that we’ve addressed how working capital is presented, what does working capital tell us?

So, what does the company’s negative $16.6 million working capital balance tell us?

For starters, it tells us that there are $16.6 million more liabilities coming due over the next year than assets that can be converted within the year – which might perhaps be a troubling metric.

If all of Noodles & Co’s accrued expenses and payables are due next month, while all the receivables are expected 6 months from now, there would be a liquidity problem at Noodles.

For example, they’d need to borrow, sell equipment, or liquidate inventory (i.e. convert into cash on hand).

But the same negative working capital balance could be telling a completely different tale, namely of healthy and efficient working capital management, where accounts payables, accounts receivable and inventory are carefully managed to ensure that inventory is quickly sold and cash is quickly collected, allowing Noodles & Co to pay invoices as they come due and purchase more inventory without tying up cash and without skipping a beat.

Further, Noodles & Co might have an untapped credit facility (revolving credit line) with sufficient borrowing capacity to address an unexpected lag in collection.

In fact, here’s how Noodles & Co explains their negative working capital in the same 10-Q:

Noodles & Co. Commentary

“Our working capital position benefits from the fact that we generally collect cash from sales to customers the same day, or in the case of credit or debit card transactions, within several days of the related sale, and we typically have up to 30 days to pay our vendors. We believe that expected cash flow from operations, the proceeds received from the private placement transactions and existing borrowing capacity under our credit facility are adequate to fund debt service requirements, operating lease obligations, capital expenditures, the Restaurant Closing Liabilities, the Data Breach Liabilities and working capital obligations for the remainder of fiscal year 2017.”

^{(Source: NDLS 10–K)}

In short, the amount of working capital on its own doesn’t tell us much without context. Noodle’s negative working capital balance could be good, bad or something in between.

How to Calculate Working Capital Cycle

Cash, accounts receivable, inventories and accounts payable are often discussed together because they represent the moving parts involved in a company’s operating cycle (a fancy term that describes the time it takes, from start to finish, of buying or producing inventory, selling it, and collecting cash for it).

For example, if it takes an appliance retailer 35 days on average to sell inventory and another 28 days on average to collect the cash post-sale, the operating cycle is 63 days.

• Operating Cycle = 35 days + 28 days = 63 days

In other words, there are 63 days between when cash was invested in the process and when cash was returned to the company.

Conceptually, the operating cycle is the number of days that it takes between when a company initially puts up cash to get (or make) stuff and getting the cash back out after you sold the stuff.

Since companies often purchase inventory on credit, a related concept is the working capital cycle—often referred to as the “net operating cycle” or “cash conversion cycle”—which factors in credit purchases.

The working capital cycle formula is days inventory outstanding (DIO) plus days sales outstanding (DSO), subtracted by days payable outstanding (DPO).

In our example, if the retailer purchased the inventory on credit with 30-day terms, it had to put up the cash 33 days before it was collected. Here, the cash conversion cycle is 33 days, which is pretty straightforward.

• Cash Conversion Cycle (CCC) = 35 days + 28 days – 30 days = 33 days

Working Capital Metric: Quick Formula Chart

How to Optimize Working Capital Management

For many firms, the analysis and management of the operating cycle is the key to healthy operations.

For example, imagine the appliance retailer ordered too much inventory – its cash will be tied up and unavailable for spending on other things (such as fixed assets and salaries). Moreover, it will need larger warehouses, will have to pay for unnecessary storage, and will have no space to house other inventory.

Imagine that in addition to buying too much inventory, the retailer is lenient with payment terms to its own customers (perhaps to stand out from the competition). This extends the amount of time cash is tied up and adds a layer of uncertainty and risk around collection.

Now imagine our appliance retailer mitigates these issues by paying for the inventory on credit (often necessary as the retailer only gets cash once it sells the inventory).

Cash is no longer tied up, but effective working capital management is even more important since the retailer may be forced to discount more aggressively (lowering margins or even taking a loss) to move inventory in order to meet vendor payments and escape facing penalties.

Taken together, this process represents the operating cycle (also called the cash conversion cycle).

Companies with significant working capital considerations must carefully and actively manage working capital to avoid inefficiencies and possible liquidity problems.

In our example, a perfect storm could look like this:

1. Retailer bought a lot of inventory on credit with short repayment terms
2. Economy is slow, customers aren’t paying as fast as was expected
3. Demand for the retailer’s product offerings change and some inventory flies off the shelves while other inventory isn’t selling

In this perfect storm, the retailer doesn’t have the funds to replenish the inventory that’s flying off the shelves because it hasn’t collected enough cash from customers.

Working Capital Calculator — Excel Template

We’ll now move to an illustrative working capital example of Noodles & Co.

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Working Capital Calculation Example

While our hypothetical appliance retailer appears to require significant working capital investments (translation: It has cash tied up in inventory and receivables for 33 days on average), Noodles & Co, for example, has a very short operating cycle.

We can see that Noodles & Co has a very short cash conversion cycle (<3 days).

On average, the Noodles needs approximately 30 days to convert inventory to cash, and Noodles buys inventory on credit and has about 30 days to pay. Hence, the company exhibits a negative working capital balance with relatively limited need for short-term liquidity.

The suppliers, who haven’t yet been paid, are unwilling to provide additional credit, or demand even less favorable terms.

In this case, the retailer may draw on their revolver, tap other debt, or even be forced to liquidate assets. The risk is that when working capital is sufficiently mismanaged, seeking last-minute sources of liquidity may be costly, deleterious to the business, or in the worst-case scenario, undoable.

While each component—inventory, accounts receivable and accounts payable—is important individually, collectively the items comprise the operating cycle for a business, and thus must be analyzed both together and individually.

Working capital as a ratio is meaningful when it is compared, alongside activity ratios, the operating cycle and the cash conversion cycle, over time and against a company’s peers.

Put together, managers and investors can gain critical insights into the short-term liquidity and operations of a business.

Working Capital Guide: Closing Remarks

Below we summarize the key takeaways we’ve described from the presentation of working capital on the financial statements:

• While the textbook definition of working capital is current assets less current liabilities, finance professionals refer to the subset of working capital tied to operating activities as simply working capital.
• The balance sheet working capital items include both operating and non-operating assets and liabilities whereas the “changes in working capital” section of the cash flow statement only includes operating assets and liabilities and
• The cash flow statement informally named “changes in working capital” section will include some non-current assets and liabilities (and thus excluded for the textbook definition of working capital) as long as they are associated with operations.