Companies must have adequate working capital to support their operations and grow. The amount of working capital is an important indicator of the financial health of a business. Understanding the nature of working capital and how to use it is an important skill for all business managers.
Gross Working Capital
Gross working capital is the total amount of a company's current assets. It includes cash on hand, accounts receivable, inventory and short-term investments. Liabilities are not included in this calculation, so gross working capital offers only a limited description of a company's financial status.
Net Working Capital
Net working capital is a more accurate and complete measure of the liquidity health of a business. It is calculated by adding up the firm's current assets – cash, short-term investments, accounts receivable and inventory – and subtracting all of its current liabilities. (Working Capital Ratio = Current Assets minus Current Liabilities) Examples of items in current liabilities are: accounts payable, customer deposits, short-term loans, interest payable, taxes, current maturities of long-term debt and all other liabilities due within one year.
While net working capital is a dollar amount and is important to track, the ratio of current assets to current liabilities tells more about the liquidity condition of a company.
Importance of the Working Capital Ratio
The cash-flow cycle of a business from inventory to receivables to cash is not always steady and perfect. Managers can never be entirely certain that they will consistently have enough cash available to pay their bills. On the other hand, the amounts and due dates of current liabilities are well defined. Creditors expect payments on specific due dates, without exception.
For this reason, businesses try to maintain an amount of current assets that is well in excess of the amount of current liabilities. Generally, most managers try to maintain a working capital ratio of 2:1. In other words, they want to have two dollars in current assets for each dollar in current liabilities. When the working capital ratio falls below 1:1, the business will have difficulties meeting its debt obligations on time, so a higher current ratio is better for maintaining adequate liquidity.
Weaknesses in Interpreting the Working Capital Ratio
Even though a company may have a high working capital ratio, it does not necessarily mean that the business has a strong liquidity position. For example, there might be some products in inventory that are old, obsolete and unsalable. These items will not be contributing to the firm's cash flow. In addition, Accounts Receivable could have amounts due from customers that are late or, worse, not even collectible. In either case, further analysis of the quality of inventory and receivables would be necessary to determine the real working capital position of the company.
How to Increase Working Capital
Firms can try to speed up their cash-flow conversion cycle and increase working capital with these methods:
- Shorten credit payment terms to customers.
- Be more aggressive in collection of outstanding receivables.
- Reduce inventory levels by using just-in-time purchases.
- Clean out unused inventory by returning to suppliers or selling at discounts.
- Ask suppliers to extend their accounts payable terms.
Every business needs sufficient working capital to meet its short-term financial commitments on a timely basis. The working capital ratio should be high enough to provide reserves to take advantage of opportunities when they appear and to weather financial downturns. Since a firm's cash-flow conversion cycle is not always steady, maintaining a comfortable working capital position is essential for the long-term survivability and growth of a business.
- The Motley Fool: What Is Net Working Capital and How Is It Different From Gross Working Capital?
- The Balance: What Is the Current Ratio and How Do You Measure It?
- Purdue Center for Commercial Agriculture: Working Capital: What Is It and Do You Have Enough?
- Accounting Tools: Net Working Capital
- Corporate Finance Institute: What Is the Working Capital Formula?
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