Strong working capital is necessary for businesses with an eye toward growth and expansion. Defined as the difference between a company’s current assets and liabilities, working capital plays a major part in providing resources for growth and cash flow.
Although the calculation may seem relatively simple, the impact of working capital is a bit complex.
What Is Working Capital?
The calculation of working capital is straightforward:
Current Assets − Current Liabilities = Working Capital
“Current” is a keyword in this calculation. The assets used in figuring working capital are generally limited to those that can be successfully converted to cash within 12 months. This limits the components to the most immediate debts and liquid assets.
Working capital provides a snapshot of a company’s short-term cash flow. If a company has positive working capital, it probably has the opportunity to propel growth, expansion, and investments. If working capital is negative, the company may have problems funding projects and paying off credit bills.
Calculating working capital may seem easy, but it reflects differently on different industries. Businesses that have long production cycles — auto manufacturers, machinery producers, aerospace companies, electronics makers, and others — typically need more working capital to source materials, maintain assembly lines, and set up distribution.
Businesses with short production cycles, such as retailers and service-based companies, do not require as much working capital. Their core activity is marketing a pre-made product or service and selling it to others — sometimes dozens of customers over a single day. This means they can get short-term funds fairly quickly, so they can navigate around the lower capital.
What Is Included in a Company’s Current Assets and Liabilities?
Current assets in a working capital calculation may include:
- Cash on hand
- Cash equivalents
- Accounts and notes receivable
- Prepaid expenses
- Inventory (if applicable)
Current liabilities might cover:
- Accounts payable (supplies, rent, property taxes, operating expenses)
- Wages payable
- Portions of long-term debts that must be paid within 12 months
- Accrued tax payable
- Dividends paid to shareholders
- Advance capital funding a current or future project (unearned revenue)
Working capital gives a more immediate picture of a company’s current financial health, daily operations, short-term liability, and overall efficiency.
Working Capital and Cash Flow
Working capital is directly related to liquidity and cash flow. However, the difference between positive and negative working capital is a bit more nuanced.
When a company has positive working capital, it can pay off short-term obligations and invest in growth more easily. While it’s better to have positive working capital than negative, too much working capital in reserve might signal trouble. The company may be using cash inefficiently, stocking excess inventory, or just holding on to too much idle cash. It’s not a “good problem to have” — it’s a cash flow management issue.
Similarly, negative working capital isn’t always a sign of impending doom. Some companies — retailers especially — frequently operate under negative working capital. That’s because they handle multiple transactions a day and cash is always coming in.
If the company’s suppliers or creditors have agreed to extended payment terms, it has more money coming in than it has to pay off suppliers. This implies positive cash flow even if the working capital remains negative.
Generally speaking, most companies want to eventually get to a point of positive working capital. But if carefully managed, negative working capital can be endurable, at least in the short term.
Raising Working Capital
Businesses have a few options if they’re looking to maintain positive working capital and improve liquidity. In basic terms, they need to increase assets and decrease liabilities.
To increase assets, a company can put cash in savings, increase its inventory, prepay discount expenses, or (carefully) extend credit to lessen the effect of bad debts.
To reduce liabilities, a company can negotiate for better credit terms with its suppliers or service providers, manage spending, and steer clear of incurring nonessential debt.
Guidance on Managing Working Capital
A fractional CFO can offer plenty of resources for improving working capital. They can refine cash flow to speed up the conversion cycle. They can manage inventory levels and credit policies to streamline liquidity. They can provide keen insights into budgeting, projections, and risk management — all the components that intersect to analyze working capital.
The fractional CFOs at Zabel & Co. can optimize your company’s working capital and cash flow to put your business in the most advantageous position. Get in touch with us to find out more.