Working capital is the difference between current assets and current liabilities. Prepaid expenses are costs that have already been paid by a company but the service or product exchange has yet to occur. Prepaid expenses that are due within one year can be counted as current assets in a working capital calculation for that year.
Key Takeaways
- Working capital is the difference between current assets and current liabilities.
- Current assets are those that a company reasonably expects can be converted into cash within one year.
- Current liabilities are a company’s bills and other obligations that are due within one year.
- Prepaid expenses are a current asset and are included in working capital.
- Working capital helps determine whether a company can meet its short-term obligations.
A Closer Look at Working Capital
Calculating the working capital of a company is a way to measure its short-term financial condition and operational efficiency. The formula for working capital is:
Working Capital = Current Assets – Current Liabilities
Current assets are those that a company reasonably expects to convert into cash within one year. This can include cash, accounts receivable, and inventory. Current liabilities are a company’s bills and other obligations that are due within one year. They include short-term debt and taxes due.
Looking at working capital can help a company understand the strength of its ability to meet its short-term obligations and assess how efficiently the company is using its resources. This information assists management in making good investment decisions and provides a better understanding of how to manage the business. It also helps investors gauge how effectively management is running the company.
A Closer Look at Prepaid Expenses
Prepaid expenses are costs that the company has already paid for but has not yet incurred. The actual expense occurs in the future so it’s classified as an asset that the company holds on its balance sheet.
Important
It’s considered a current asset if the value exchange for a prepaid expense is expected to occur within a year and it can be counted as such when determining working capital.
Prepaid Expense Example
An example of a prepaid expense is a company paying for a full year of insurance premiums in a lump sum at the beginning of the year.
The payment has already been made for 12 months but only the current month’s premium is considered a current expense. The sum of the remaining 11 premiums is bucketed into a prepaid insurance account that’s classified as a current asset on the balance sheet and in a working capital calculation. The prepaid insurance expense is then expensed as the insurance is used.
Let’s say Company ABC paid $12,000 for its yearly insurance in advance. The company books $1,000 as an insurance expense for the current month and $11,000 as a prepaid expense for the remaining 11 months. The cash account is credited for $12,000. The company moves $1,000 from prepaid expenses to the insurance expense account in month two by crediting prepaid expenses and debiting insurance expenses.
What Are Some Options If a Company Has Insufficient Working Capital?
The overall approach to remedying this problem is similar to that of an individual whose income is insufficient to meet their budget. Options include cutting costs where possible. Costs of operation are necessary to raise income so cutting might involve renegotiating loans and other accounts payable to reduce them at least temporarily. Increasing efforts to collect on delinquent and outstanding accounts receivable can help as well.
How Common Are Prepaid Expenses?
Companies may prepay many types of expenses. They include rent, utility bills, taxes, and maintenance services. These expenses can each have their own account within the company’s accounting system or they can be pooled together in one account.
What Is a Good Working Capital Ratio?
A working capital ratio of 1.5 to 2 is generally accepted as good. A higher number isn’t better. It indicates that a company isn’t managing its assets effectively.
The Bottom Line
Prepaid expenses are company costs that have been paid although the product or service hasn’t yet been delivered. Estimated taxes and insurance policies are examples. They’re considered to be assets and are therefore included in the calculation of a company’s working capital.