What is Working Capital Formula?
Working capital is a measure of a company’s liquidity in the short term. Also referred to as net working capital (NWC), it’s the difference between current assets and current liabilities. It shows whether a company has sufficient liquidity to meet its short-term obligations.
How to calculate working capital
The formula for calculating working capital is:
Working capital = current assets - current liabilities
Current assets are liquid assets or those expected to be sold or consumed within a year. A company’s balance sheet typically lists its current assets. Current assets include:
- Cash equivalents
- Stock inventory
- Accounts receivable
- Raw materials inventory
- Pre-paid liabilities
- Marketable securities
- Other liquid assets
As a general rule of thumb, current assets are any assets that the company can convert to cash within the span of a year. Current assets exclude illiquid assets, including long-term assets like plants and machinery.
Current liabilities are financial obligations the company must pay within a year. The components of current liabilities include:
- Accounts payable
- Income taxes owed within a year
- Interest expenses
- Short-term debt
- Deferred revenue due in a year
- Commercial papers
- Dividends payable
- Long-term debt maturing in a year
The company’s balance sheet lists all the components that go into the calculation of current assets and current liabilities. The difference between current assets and current liabilities equals the company’s working capital.
Understanding working capital
Current liabilities are the sum of all the financial obligations that a company must meet within the short term. Current assets should cover current liabilities. This is where working capital comes into play. A company has positive working capital when its current assets are larger than its current liabilities. It means the company can expect to meet its short-term financial obligations.
On the other hand, a company has negative working capital when its current liabilities exceed current assets. This means the company will face difficulty in meeting its financial obligations due within a year. The company will have to raise capital to meet short-term obligations or default on its obligations. The company’s circumstances may worsen, potentially forcing it into bankruptcy and/or dilution due to defaults.
The company will also need to have sufficient working capital to expand its operations or for other investments to grow the company. Working capital is also an indicator of the strength of the company’s cash flows. Accounting profits alone are not sufficient to run a company. Having adequate working capital supported by strong cash flow is essential.
The working capital required is different for every company. Some businesses are inherently capital intensive, and some need very little capital to run. When assessing the strength of the working capital of a company, compare it with industry peers to gain a better understanding.