This article is for educational purposes and does not constitute financial, legal, or tax advice. For specific advice applicable to your business, please contact a professional.
Working capital (WC), also known as net working capital (NWC), is a company’s net current assets and is calculated from the information shown on a company’s balance sheet. Working capital is generally seen as a useful indicator of a company’s health – and the quality of its management.
Example of working capital
The basic working capital formula is:
Current Assets - Current Liabilities = Working Capital
The working capital ratio formula is:
Current Assets/Current Liabilities = Working Capital Ratio
Understanding working capital
Working capital is always stated as a monetary figure, and if it’s below zero, the business’s short-term obligations exceed its short-term assets. Such a situation must be addressed as a priority.
If the figure is exactly zero, the business has just enough short-term assets to cover its short-term obligations. This is still a precarious situation, as any negative movement in current assets will lead to negative net working capital.
For example, current assets include accounts receivable. If debtors are late in paying these, a business with zero net working capital is likely to suffer from cash-flow issues. If the accounts receivable have to be written off as bad debt, the business will drop into negative net working capital.
By contrast, if a business has positive net working capital, it can meet its short-term obligations with cash to spare, so is much less at risk.
Understanding the working capital ratio
The working capital ratio is a convenient way of indicating a company’s working capital in practical terms, and allows stakeholders to gauge a company’s financial health without having to analyze its financial statements.
For example, saying that a company has $20K working capital means little in isolation. It could mean that a company has $100K of current assets and $80K of current liabilities, or $40K of current assets and $20K of current liabilities.
But stating the working capital ratio makes the difference clear immediately. In the first instance, it is 1.25, whereas in the second it is 2. Likewise, using the working capital ratio also makes it easier to track a company’s performance over time and compare it with other companies.
Managing working capital
Managing working capital is a balancing act. Companies must ensure they have enough current assets to cover their short-term obligations, as well as sufficient cash to protect them from unforeseen events. At the same time, excessive amounts of working capital ties up a company’s resources without bringing in benefits.
Companies must decide where to draw a line between reasonable safeguarding and excessive caution. As a rule of thumb, a working capital ratio of between 1 and 3 is acceptable, with 1.5 to 2 considered ideal. There are, however, wide variations between industry sectors.
For example, large supermarkets can have very low working capital ratios, even going below 1 because they are usually good at negotiating extended credit terms with suppliers and optimizing their inventory. By contrast, clothing retailers and specialty food retailers tend to have high working capital ratios due to the size and value of their inventory.