If financial teams want to determine if their businesses can weather a sudden downturn or catastrophe, they need a firm grasp on working capital and cash flow. These two measurements may show different facets of a company's financial health. Working capital refers to a company's ability to turn its current assets, such as cash and short-term investments, into cash within a year.
The Importance of Working Capital
A company's working capital is estimated using its various assets and liabilities. For a more accurate picture of the company's short-term liquidity, it's important to focus on current liabilities and offset them with the most liquid assets.
A corporation with significant positive NWC may be able to make strategic growth investments. A business must have current assets that are greater than its current obligations. Bankruptcy is a real possibility.
How Do You Figure Out Working Capital?
To determine a company's working capital, take its current assets and subtract its current liabilities. With $100,000 in current assets and $80,000 in current liabilities, a corporation has $20,000 in working capital. Cash accounts receivable and inventory are all examples of current assets.
What Role Does Working Capital Play in a Business?
Businesses can't survive without a steady infusion of working cash. Though unlikely, a financially successful company can fail. After all, a company needs actual cash on hand to pay its expenses, not just the promise of future revenues. Let's pretend a company has saved $1,000,000 thanks to retained earnings. The firm may not have enough liquid assets to cover its short-term debts if it decides to invest all $1 million at once.
The formula for Calculating Working Capital
Working capital is the difference between a company's current assets and liabilities. The two numbers are included in publicly available financial accounts for publicly traded corporations, but for privately held businesses, this information may be harder to come by.
Working Capital = Current Assets - Current Liabilities
The term "working capital" is typically followed by a numerical value. If a corporation, as an illustration, has $100,000 in current assets and $30,000 in current liabilities, the company is in a negative cash flow position. Therefore, $70,000 is considered "working capital" for the business.
This means that the corporation has access to $70,000 in short-term funding for any purpose it may require. When a company's current assets exceed its current liabilities, the result is positive working capital. If all current assets were sold to pay off short-term debt, the corporation would still have cash on hand.
What Makes Up Working Capital?
Although a corporation may not need all of the aspects of working capital listed below, all of them may be found on a balance sheet. A service business that does not maintain stockpiles of goods would naturally exclude inventories from its working capital analysis.
Cash, accounts receivable, inventory, and any other assets that may be converted to cash in less than a year are all considered current assets. Payroll, taxes, and other employee benefits, as well as the interest and principal due on long-term debt within a year, all, fall under the category of current obligations.
Constrained Working Capital
Determine the short-term viability of a business by looking at its working capital. However, the formula has a few flaws that can render the measure inaccurate in some cases. First, working capital is continually changing. A business will adjust several of its current asset and liability accounts.
For this reason, the company's working capital situation may have altered when the necessary financial data is collected. The several forms of accounts that make up a business are ignored by working capital. Consider an organization whose only source of short-term funding is from outstanding invoices.
Special Considerations
Investing money at the outset is typical for large new projects like production increases or entering new markets. In the short term, this decreases available funds. As a result, firms that are spending their working capital inefficiently or that require additional capital upfront might improve their cash flow by exerting pressure on their suppliers and consumers.
On the other hand, it's not always preferable to have a lot of working capital. This might mean the company is sitting on extra cash or goods or doing nothing productive with the money.
Working Capital: An Example
Microsoft (MSFT) has $174.2 billion in current assets as of 2021. All current assets were counted, such as money on hand, investments with a short-term return, accounts receivable, stock on hand, and other similar items. The corporation also stated that accounts payable, current components of long-term obligations, accrued compensation, short-term income taxes, unearned revenue, and other current liabilities totaled $77.5 billion.
Therefore, Microsoft's working capital was $96.7 billion by the end of 2021. After paying off all of its current liabilities and selling off all of its current assets, Microsoft would be left with about $100 billion in cash.
