Working capital is a common metric that’s used to measure a company’s liquidity or its ability to generate cash to pay for its short-term financial obligations. Working capital also provides insight into the operational efficiency and overall financial health of a company. It’s the capital necessary for a business to maintain its daily functions. It requires a certain amount of cash on hand to cover unexpected costs, regularly pay bills, and buy raw materials that are used in production.
Key Takeaways
- Working capital is a metric that’s used to measure a company’s liquidity or its ability to generate cash to pay for its short-term financial obligations.
- Working capital is the difference between a company’s current assets such as cash and its current liabilities such as its debts.
- A company that has positive working capital has enough liquidity or cash to pay its bills in the coming months.
- Working capital provides insight into the operational efficiency and overall financial health of a company.
Working Capital As a Measure for Liquidity
Working capital is the difference between a company’s short-term assets such as cash and its short-term liabilities such as its debts or bills. A company that has positive working capital has enough liquidity or cash to pay its bills in the coming months.
Liquidity essentially measures a company’s ability to pay off its bills when they’re due or how easily and effectively it can access the money it needs to cover its debts. Working capital reflects the liquid assets that a company uses to make such debt payments.
Drivers of Working Capital Liquidity
The two components of working capital are current assets and current liabilities.
Current Assets
Current assets are those that are expected to be used up within the next 12 months. Examples include:
- Cash and cash equivalents
- Accounts receivable which are the payments owed by customers for products and services that have been sold
- Inventory which can consist of merchandise and finished goods that can be liquidated or sold to raise cash
- Marketable securities which are investments that aren’t locked up and can be easily redeemed for cash
- Prepaid expenses which include any payments to contractors or vendors for services or products that haven’t yet been received
Current Liabilities
Current liabilities are short-term debts or bills that a company owes within the next 12 months. They’re typically paid by using current assets. Examples of current liabilities include:
- Accounts payable which are debts owed to suppliers and vendors
- Wages payable that are due to employees within the next year
- Short-term debt which includes bank loans that are used to fund the company’s operating expenses
- Dividends payable which are cash payments due to equity shareholders as a reward for being an investor in the company
- Current portions of long-term debt that are in the next 12 months
- Interest payable on outstanding debts including long-term obligations
- Income taxes that are due within the next year
Interpreting Working Capital Liquidity
Working capital is the measure of how well a company can sell its current assets to pay its current liabilities. A company could sell some of its merchandise inventory or withdraw cash from its marketable securities if it has accounts payable coming due in 30 days.
A company could run into difficulty paying its accounts payable, however, if it didn’t have enough merchandise inventory, any cash on hand, or marketable securities. Investors and equity analysts as well as banks that extend credit to companies analyze whether a company has sufficient current assets to cover its current liabilities as a result.
Working capital reflects various company activities such as debt management, revenue collection, payments to suppliers, and inventory management. These are reflected in working capital because it includes not only cash but also accounts payable, accounts receivables, inventory, and portions of debt that are due within one year.
A company can improve its working capital by collecting its accounts receivables from its customers sooner or by asking suppliers for a short-term extension on the due dates for their accounts payables. Several factors affect working capital needs including asset purchases, past-due accounts receivables being written off, and differences in payment policies.
Important
The working capital necessary to operate a business varies between industries.
Positive Working Capital/Liquidity
A company that has an excess of current assets with which to meet its current liabilities has positive working capital. A company with the ability to generate cash is in a better position to weather any upcoming storms or challenges. Positive working capital affects a company’s operations in a few ways.
Banks
Positive working capital can help a company obtain credit and better terms for loans from banks. Better credit terms might mean a lower interest rate on long-term debt or the ability to establish a working capital credit line with a bank. A credit line is a credit facility that banks provide to businesses so they can tap into it when necessary.
The credit line is paid off when enough revenue has been generated and the company again has access to that liquidity if it’s needed in the future.
Suppliers
Suppliers and vendors that allow companies to pay them back via accounts payable are also essentially extending credit to the company. A payable might be due in 30, 60, or 90 days. The company would use the supplies that were bought on credit to manufacture their product and generate sales. The revenue from those sales would be used to pay off their accounts payables due to the suppliers.
A supplier would need assurances that the company is financially viable before it would agree to accept an accounts payable. Measuring the company’s working capital enables the supplier to ascertain whether the company has the financial resources to pay them back.
Excessive Liquidity
Too much working capital could mean that a company isn’t adequately using its cash. A company with an excessive amount of working capital might be better off putting the money to use by purchasing new equipment, hiring workers to boost production or sales, or paying down debt.
Negative Working Capital/Inadequate Liquidity
Negative working capital can indicate short-term cash issues or a more serious long-term management issue if it’s persistent. A company might experience negative working capital for a few reasons.
Cash Outlays
Negative working capital could be caused by a company making a large cash outlay for buying equipment or paying down debt. Many companies experience periods of negative working capital. Many of them have working capital credit lines established with their bank for this reason.
Brief periods of negative liquidity might not be a reason for concern and should be compared with other companies in the same industry.
Seasonal Businesses
A company that sells products in a seasonal business might spend a lot of cash and need to borrow from a bank to hire workers, buy inventory, and access raw materials leading up to their busy season. The company would show negative working capital during this time as they ramp up production. The revenue generated is used to pay their accounts payables, short-term debt, and borrowing facilities, however, when the seasonal sales begin coming in.
Retailers typically generate the vast majority of their sales during the holiday season. The working capital for these companies can fluctuate wildly throughout the year as a result.
Long-Term Issues
Companies that are struggling financially will typically have negative working capital for an extended period. Negative liquidity is a red flag for investors and creditors because it can be symptomatic of poor operational management, debt management, and mismanagement of their payables and receivables. It can create a cash flow shortfall if a company’s customers aren’t paying them on time, leading to late payments on their bank debt and accounts payables.
How Do Marketable Securities Affect Liquidity?
A company can sell marketable securities to raise capital quickly. Maturity dates are typically short-term, one year or less. These securities are sold on public exchanges and they appear on a company’s balance sheet as assets because of their superior liquidity. They can be sold on public exchanges.
What Qualifies As a Long-Term Asset?
Long-term assets are those a company holds and uses for a period longer than one year. These assets can be tangible or intangible and they typically facilitate a company’s ability to stay in business. They can include patents, trademarks, buildings, and machinery. They appear on a company’s balance sheet and are sometimes referred to as non-current assets.
How Long Can a Company Operate With Negative Working Capital?
The situation obviously can’t go on indefinitely because the company will eventually go out of business. Maintaining negative working capital can be a short-term strategy for some businesses, however. It can occur in an effort to improve efficiency or negotiate credit and this might remedy a short-term issue or problem.
The Bottom Line
A company’s working capital is the difference between its current assets and its current liabilities. Healthy working capital indicates that a company has sufficient cash and/or assets that can be converted to cash relatively quickly so it’s in no danger of being unable to pay its short-term bills and obligations.
Working capital also shines a spotlight on the company’s overall financial health. A company with negative working capital can be a red flag for investors, particularly if it endures these periods with some frequency.