Working capital is what’s left when the sum of a company's current liabilities (including accounts payable to it by customers or clients) is deducted from its total current assets. Current assets include raw materials belonging to the company, finished goods inventories, cash and customers' unpaid accounts.
Working Capital can also be referred to as net working capital (NWC) and be used to measure the financial health of a company, as well as give the company, its advisors and potential investors an indication as to its liquidity and operational efficiency. A company needs working capital in order to be able to invest in itself and to grow. If a company does not have enough working capital, it may struggle to pay its liabilities as they become due or may even find itself at risk of becoming insolvent.
How to calculate Working Capital?
The standard working capital formula to remember is the company's assets minus its liabilities equals working capital.
To determine how to calculate the working capital in more detail, compare a company's current assets, as listed on its balance sheet, to its current liabilities. The current assets you can expect to find will include all those which the company expects to be able to liquidate or turn into cash within a 1 year period. These will include, for example, inventories of raw materials and stock, cash and accounts receivable from clients or customers.
From the total of these assets, you need to deduct the total of all current liabilities. Current liabilities - like current assets - also refers to those liabilities which will be due within a 1 year period. These current liabilities will include taxes, wages payable by the company, accounts the company is liable to pay and a proportion of any longer-term debt.
A company will generally be looking to maintain working capital in line with what is usual for companies in the same industry sector of a similar size. Usual working capital levels will vary from industry to industry. A higher working capital value is not necessarily desirable, because if it is too high it can indicate problems with a company holding excessive inventory or failing to make its cash work hard by using it for investment in growth and development.
Working Capital Example
We have seen that to calculate working capital, we need to deduct current liabilities from current assets. If a company's current assets are £150,000 and its current liabilities are £100,000, the working capital is £150,000 less £100,000 which amounts to £50,000.
Working Capital Ratio
The working capital ratio is the ratio between current assets and current liabilities. Ideally, in the opinion of many experts, a company should aim for a working capital ratio of around 1.2 to 2 although this will vary. If the ratio is less than one, the company has negative working capital. Positive working capital, on the other hand, means that the company has the means to carry on its business and also invest for the future.
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