Working capital is a financial figure that represents the liquidity of a business based on available current assets and current liabilities. To calculate working capital, simply subtract a company’s total current assets from total current liabilities. For example, if a company has $1 million United States Dollars (USD) in current assets and $750,000 USD in current liabilities, working capital is $250,000 USD. While this example indicates working capital as a positive figure, it is possible to have negative working capital during the lifetime of a business.
When attempting to calculate working capital for a company, one can obtain all of the necessary information from the balance sheet. Current assets are typically listed first on the balance sheet. This number includes cash and cash equivalents, accounts receivable, inventory, prepaid accounts, and short-term investments. The last two items are only included in current assets if they expire in 12 months or less. Analysts and investors use current assets to calculate working capital because these items represent assets that are easier to turn into cash than other items owned by the company.
Current liabilities are items that companies are financially obligated to pay within the next 12 months. These items include accounts payable and short-term loans such as credit lines, credit cards, and other short-term debt obligations. These debts typically arise because of normal operations in business. Although these items are not commonly secured by collateral, they do represent legal obligations that must be paid.
Financial analysts and accountants may use a working capital ratio when attempting to calculate working capital. This ratio provides a statistical indicator to compare against the industry standard or leading competitor’s working capital ratio. The ratio used to calculate working capital is current assets divided by current liabilities. Using the figures from the previous example, a company’s working capital ratio is 1.33 (1,000,000 / 750,000). If this figure is less than 1.0, it indicates the company has negative working capital. A figure over 2.0 may signal a company has excessive assets and is not using them to generate more capital. Therefore, an ideal working capital ratio is between 1.0 and 2.0.
Using the working capital ratio provides a different level of understanding for company management. Changing the current asset figure from the previous example, assume current assets of $2,000,000 USD and current liabilities of $750,000 USD. While the working capital formula indicates positive working capital of $1,250,000 USD (2,000,000 – 750,000), the ratio is 2.67 (2,000,000 / 750,000). Therefore, company management may need to use the company’s short-term assets to generate higher revenues.