Working capital is the difference between a company’s current assets and liabilities, used to determine short-term financial health. Changes occur when either item increases or decreases. It is important for lenders and investors to assess a company’s financial health.
Working capital is a basic accounting formula that businesses use to determine their short-term financial health. The basic formula is current assets minus current liabilities. Changes in working capital will occur when either of these two items increases or decreases in value. Both current assets and current liabilities are found on a company’s balance sheet. Each group represents items of business property or obligation to pay for services and goods, respectively. Significant changes, whether positive or negative, in working capital can send mixed signals to internal and external business stakeholders.
Current assets include cash and cash equivalents, inventory, accounts receivable, and notes receivable. These items include assets that a business will use in less than 12 months in its business operations. For working capital to change, one of these items will need to increase or decrease. Accounting transactions may involve two or more of these accounts, which will have no effect on the working capital formula. For example, an asset swap transaction occurs when a company collects cash for prior sales on account. This increases cash while decreasing accounts receivable.
Current liabilities include accounts payable, trade credit, short-term loans, and lines of credit. Like current assets, these companies must pay these financial obligations in less than 12 months. Asset exchange transactions generally do not occur in current liabilities. Changes in working capital will occur when these items increase or decrease. To decrease current liabilities, companies will generally use cash from their current assets, so working capital will not change as both current assets and current liabilities will decrease together. Companies that pay current liabilities by refinancing loans or using a line of credit to pay off an accounts payable balance will change their working capital balance.
Working capital is an important concept in business because all companies must have cash to pay for expenses related to business operations. Banks, lenders and investors look at this number and the resulting changes in working capital to assess the financial health of a company. Companies with large swings from positive to negative working capital can tell lenders and investors about the company’s business practices. Not generating enough capital from accounts receivable is a common problem. Businesses will sell goods on account, but face difficulties collecting outstanding balances. This results in large bad balances that will reduce the company’s working capital. It also means that companies must find other ways to generate cash to pay for short-term financial needs.
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