What is Working Capital?

Published by Thomas Herold in Accounting, Corporate Finance, Investments

'Working Capital' is explained in detail and with examples in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.

Working Capital is a company metric. This proves to be a useful corporate measurement for two significant purposes. On the one hand it is a metric for discerning shorter-term financial health. On the other hand, it is also a means of ascertaining the firm’s efficiency. The equation for working capital is current assets minus current liabilities. The working capital ratio is defined as current assets divided by current liabilities. This reveals if a corporation possesses sufficient shorter term assets to cover its shorter term time frame debt liabilities. Sometimes this concept is also referred to as net working capital.

When the number comes in at less than one, this reveals a negative working capital (also known sometimes as W/C). Any number which proves to be higher than two means that the company does not sufficiently invest its excessive assets. The most highly desired ratio proves to be a figure between 1.2 and 2.0.

The sobering facts are that when the firm’s current assets are not greater than its current liabilities, it can run afoul of its creditors and the ability to repay them over the shorter term. In the worst case, bankruptcy can ultimately result. Decreasing working capital ratios throughout an extended time frame serve as a prescient warning that should be carefully and thoroughly investigated by analysts and would-be investors alike. It might be that the critical company metrics of sales volumes are steadily declining over time. This would mean that the account receivables amounts would go down and continuously deteriorate little by little.

This figure also reveals to investors and analysts alike the underlying operational efficiency of the firm. Money which is tied down in the form of inventory or which other clients still have not paid to the firm in due receivables will not be available to pay down company bills and other obligations. This means that if a company has consistently slow collections, it will be revealed as a rising number in the working capital figure. The best way to understand this is through contrasting the figure from one time period through to another one or even several like time periods. Slower collections can mean that the company and its operations have potentially fatal flaws.

It is important for investors to remember that high working capital ratios do not signal good things for the company in question. Instead, it means either that they are not sufficiently investing their excess reserves, or that they possess too large an inventory. Investors know all too well that they can quickly ascertain the company balance sheet strength by considering three important categories of quality. These include asset performance, working capital adequacy, and capitalization structure.

This means that analysts can discern the real liquidity of the firm and its efficiency with regards to the current position of the firm. Companies utilize an analytical tool to successfully accomplish this. It is called the firm’s cash conversion cycle. Still, while companies like to bandy about this number in such important arenas as their annual reports, the quantity of working capital does not provide much insight on the quality of the liquidity position of the firm in question.

The cash conversion cycle proves to be the gold standard analytical tool for assessing the investment grade quality for the two crucial assets of the firm, the accounts receivable and the inventory. This CCC cycle is made up of three standards. These include the trade receivables category, the trade payables category, and the associated ratios pertaining to the inventory turnover. The three parts may be detailed in a number of days or a number of times each year.

Free Download (No Signup Required) - The 100 Most Important Financial Terms You Should Know!
This practical financial dictionary helps you understand and comprehend the 100 most important financial terms.

The term 'Working Capital' is included in the Accounting edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.