Companies with high amounts of working capital possess sufficient liquid funds needed to meet their short-term obligations. Working capital, also called “net working capital,” is a liquidity metric used in corporate finance to assess a business’ operational efficiency. It is calculated by subtracting a company’s current liabilities from its current assets.
Key Takeaways
- Working capital is an important metric of a company’s financial health, showing how easily it can cover short-term expenses with liquid assets.
- Working capital is calculated as current assets minus current liabilities.
- While a high working capital generally indicates strong financial management, too much working capital can indicate inefficiencies or missed investment opportunities.
- Working capital needs differ for every industry and a single snapshot like working capital may not be as useful as analyzing a company’s long-term trends.
Working Capital Components
Current assets are considered to be extremely liquid if they are able to be converted to cash within a calendar year. Typically, the current asset category on a company’s balance sheet includes the following items:
- The value of any cash on hand
- Checking and savings accounts
- Marketable securities like stocks, bonds, and mutual funds
- Any inventory a company plans to sell within one year
- Accounts receivable, which are debts owed by customers who have not yet paid for goods or services rendered
The current liabilities category on a company’s balance sheet includes the following items:
- All debts and expenses a company is obligated to pay within the coming 12 months
- Short-term debts
- Interest and tax payments
- Accounts payable
- The cost of supplies and raw materials, rent, utilities, and other operational expenses
Understanding High Working Capital
If a company has very high net working capital, it generally has the financial resources to meet all of its short-term financial obligations. Broadly speaking, the higher a company’s working capital is, the more efficiently it functions. High working capital signals that a company is shrewdly managed and also suggests that it harbors the potential for strong growth.
Not all major companies exhibit high working capital, however. In fact, some large corporations have negative working capital, where their short-term debts outweigh their liquid assets. Typically, the only entities capable of remaining solvent amid these circumstances are behemoth corporations with significant brand recognition and robust selling power.
Such companies are able to quickly generate additional funds, either by shuffling money from other operational silos, or by acquiring long-term debt. These companies can easily meet short-term expenses even if their assets are tied up in long-term investments, properties, or equipment rentals.
Note
Large, powerful companies that have market dominance, such as Amazon and McDonalds, can use negative working capital as a strategic advantage, allowing them to fund operations with supplier payments before having to address their own obligations.
Though most businesses strive to maintain consistently positive working capital, in some cases, very high working capital may indicate that a company isn’t investing its excess cash optimally, or that it’s neglecting growth opportunities in favor of maximizing liquidity.
In other words, a company that does not intelligently deploy its capital is potentially doing a disservice to itself and its shareholders. Extremely high net working capital may also mean the company is overly invested in inventory, or that it’s slow to collect on debts, which may indicate waning sales and/or operational inefficiencies.
Analyzing Working Capital
Because working capital figures can vary widely over time, and because they may differ from business to business, it’s important to analyze this metric within a broader, more holistic context. The industry, company size, developmental stage, and operational model of the given business must all be considered when assessing financial stability based on levels of net working capital.
In some industries, such as retail, high working capital is necessary to maintain smooth operations throughout the year. In others, businesses can run flawlessly on relatively low working capital, as long as they have consistently reliable revenues and expenses, plus stable business models.
Both the current asset and current liability figures change daily because they are based on a rolling 12-month period. Consequently, the net working capital figure fluctuates over time. Changes in this metric from year to year are especially important because long-term shifting trends are more telling of a company’s financial prospects than any single figure examined in isolation.
How Do You Calculate Working Capital?
Working capital is calculated by subtracting current liabilities from current assets: Working Capital = Current Assets – Current Liabilities. Current assets include cash, cash equivalents, and marketable securities. Current liabilities include all debts due in less than a year, accounts payable, interest, and taxes.
What Is a Good Working Capital?
What is considered a good working capital will differ for every company but more so for every industry, as different industries have different working capital requirements. Generally, a positive working capital between 1.2 and 2 is considered good. Above one means a company can cover its short-term obligations and doesn’t have liquidity issues whereas below two means it isn’t inefficiently using its capital.
Can Working Capital Be Negative?
Yes, working capital can be negative. This happens when current liabilities are greater than current assets. This may indicate that a business will have trouble paying its short-term obligations, which can lead to default. It can also lead to an over-reliance on short-term borrowing or making delayed payments to suppliers, all of which indicate financial distress.
The Bottom Line
Working capital can tell a lot about a company’s financial health but taking it into context is important. While a high working capital can indicate stability and efficiency, it isn’t always a good sign. Excess liquidity could mean a company has missed investment opportunities or has operational inefficiencies.
On the other hand, negative working capital may not be an issue for companies that do well by leveraging strong sales and brand power. As working capital fluctuates and varies by industry, it’s important to analyze alongside other financial metrics and against companies in the same industry.
