Working Capital

In This Article

• Working capital is a critical measure of a company’s short-term liquidity and operational efficiency, calculated by subtracting current liabilities from current assets,
• Analyzing the historical trends in working capital and comparing them to industry benchmarks can provide critical insights into a company’s operating performance.
• A positive working capital balance indicates sufficient cash to meet short-term obligations, implying financial stability and operational flexibility.
• A negative working capital balance raises concerns about the company’s ability to meet short-term obligations, potentially signaling financial distress and the need for immediate liquidity.
• While high levels of working capital provide a safety cushion, excessive levels can indicate inefficient asset management, such as excess inventory or poor receivables collection.
• Effective working capital management is critical to maintaining financial resilience, supporting growth initiatives, and optimizing operational performance in a competitive business environment.

How to Calculate Working Capital

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

Working capital is a core component of effective 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, working capital serves as a critical indicator of a company’s short-term liquidity position and its ability to meet immediate financial obligations.

• Current Assets ➝ Current assets 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 short-term 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 of a company—the difference between operating assets and operating liabilities—is used to fund day-to-day operations and meet short-term obligations.

Generally speaking, the working capital metric is a form of comparative analysis where a company’s resources with positive economic value are compared 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 original plan—or the delay in the issuance of an owed payment of invoices beyond 30 days—an increase in working capital can be required to sustain its operating activities.

Working Capital Formula

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

Where:

• 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)

Working Capital Example

The current assets and current liabilities are each recorded on the balance sheet of a company, as illustrated by the 10-Q filing of Alphabet, Inc (Q1-24).

The current assets section is listed in order of liquidity, whereby the most liquid assets are recorded at the top of the section.

On the other hand, the current liabilities section is listed in order of the due date, in which the near-term obligations that must be met sooner are recorded first — albeit, not all publicly-traded companies abide by that reporting convention.

Note, only the operating current assets and operating current liabilities are highlighted in the screenshot, which we’ll soon elaborate on.

^{Working Capital on Balance Sheet Example (Source: Alphabet Q1-2024)}

What are the Components of Working Capital?

Working capital is composed of current assets and current liabilities.

• Current Assets ➝ Current assets are expected to be converted into cash within twelve months (or one year), which is the time frame deemed the standard operating cycle.
• Current Liabilities ➝ Likewise, current liabilities are anticipated to be paid within a company’s twelve months.

The most common examples of current assets on the balance sheet are each defined in the subsequent table:

On the other hand, the most common current liabilities are described in the following chart:

Working Capital Ratio Formula

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, the company has net negative working capital if the working capital ratio is below 1.0x.

How to Calculate Working Capital Ratio

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. Still, 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.

What is Change in Working Capital (NWC)?

On the subject of modeling working capital in a financial model, the primary challenge is determining the operating drivers that must be attached to each working capital line item.

The 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 easy to identify and calculate working capital (current assets less current liabilities).

The change in net working capital (NWC) is tracked on the cash from operations (CFO) section of the cash flow statement (CFS)—or statement of cash flows—which reconciles net income for non-cash items like depreciation and amortization (D&A) and changes in working capital.

The cash flow from operating activities section aims to identify the cash impact of all assets and liabilities tied to operations, not solely current assets and liabilities.

To further complicate matters, the changes in working capital section of the cash flow statement (CFS) commingles current and long-term operating assets and liabilities.

Therefore, the section boxed in red on the statement of cash flows of Alphabet (NASDAQ: GOOGL) could contain changes in long-term operating assets and liabilities.

^{Change in Working Capital Section on Cash Flow Statement (Source: Alphabet Q1-24)}

How to Reconcile Change in NWC 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 and Amortization (D&A), 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 (inventory, accounts receivable, accounts payable, accrued expenses, etc.).

Those line items are thus consolidated in the operating activities section of the cash flow statement (CFS) under “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.

Net Working Capital (NWC) Formula

In practice, cash and other short-term investments, such as treasury bills (T-Bills), marketable securities, commercial paper, and any interest-bearing debt, like loans and corporate bonds, are excluded when calculating net working capital (NWC).

Why? Cash and cash equivalents, as well as debt and interest-bearing securities, are non-operational items that do not directly contribute toward generating revenue (i.e. not part of the core operations of a company’s business model).

The net working capital (NWC) calculation only includes operating current assets like accounts receivable (A/R) and inventory, as well as operating current liabilities such as accounts payable and accrued expenses.

The net working capital (NWC) metric is different from the traditional working capital metric because non-operating current assets and current liabilities are excluded from the calculation.

• Cash and Cash Equivalents ➝ The net working capital (NWC) metric must omit cash and cash equivalents, such as marketable securities and short-term investments. Cash and cash equivalents are not part of the core operations of a company’s revenue model and are closer to investing activities (i.e. interest income).
• Short-Term Debt and Interest-Bearing Securities ➝ The net working capital (NWC) metric must exclude short-term borrowings, the portion of long-term debt due within twelve months (<12), and any interest-bearing securities. Likewise, debt and interest-bearing securities are also excluded from net working capital (NWC) because such instruments are closer to financing activities (i.e. interest expense).

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

The difference between working capital and net working capital (NWC) are as follows:

What is Working Capital Peg?

One nuance to calculating the net working capital (NWC) of a particular company is the minimum cash balance—or required cash—which ties into the working capital peg in the context of mergers and acquisitions (M&A).

In short, the working capital peg is the minimum baseline amount of working capital required in order for a business to continue operating per usual post-closing of the transaction, agreed upon by the buyer and seller in an M&A transaction.

There is much negotiation that occurs between the buyer and seller in M&A, including conditional clauses, surrounding the topic of the working capital peg (or “target”).

In fact, certain practitioners include the minimum cash balance in the net working capital (NWC) metric, based on the notion that the company must retain some cash on hand to continue running its business, which is referred to as “required cash.”

Therefore, the working capital peg is set based on the implied cash on hand required to run a business post-closing and projected as a percentage of revenue (or the sum of a fixed amount of cash).

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, to buy 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 sell 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 Metrics Formula Chart

The following chart lists the most common working capital metrics:

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 time cash is tied up and adds a layer of uncertainty and risk around collection.

Suppose an 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 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:

• Poor Working Capital Management ➝ Retailer bought a lot of inventory on credit with short repayment terms
• Economic Downturn ➝ The economy is contracting, and economic growth is slowing down, so customers are not paying as quickly as expected.
• Fluctuations in Market Demand ➝ The demand for the retailer’s product offerings changes, 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 flying off the shelves because it hasn’t collected enough cash from customers.

Working Capital Calculator — Excel Template

We’ll now move to a modeling exercise, which you can access by filling out the form below.

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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 short cash conversion cycle (<3 days).

On average, 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 a 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 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 a business’s short-term liquidity and operations.

In closing, we’ll 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 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.
• The cash flow statement, informally named the “changes in working capital” section, will include some non-current assets and liabilities (and thus excluded from the textbook definition of working capital) as long as they are associated with operations.