# OCW045: Working Capital

## Calculating Working Capital

Working Capital = current assets – current liabilities.

### Learning Objectives

Calculate a company’s working capital

### Key Takeaways

#### Key Points

• WC is current assets minus current liabilities. Companies want positive WC.
• WC is an signal of whether or not the company has enough assets to turn into cash to pay upcoming expenses or debts.
• WC is a measurement of liquidity and is not a guarantee that a company can pay for its liabilities.

#### Key Terms

• liquidity: Availability of cash over short term: ability to service short-term debt.
• current liabilities: All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.
• Current Asset: An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.

Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

Working capital can be found through the following formula:

WC=CA-CL (Working Capital = current assets – current liabilities)

Current assets (CA) is an accounting term that refers to assets that can easily be turned into cash. For example, cash is a current asset, but so are most accounts receivable.

Current liabilities (CL) is an accounting term similar to CA: CL is the amount of liabilities that are expected to be settled in cash within a year (or the operating cycle of the company).

The difference between the two (WC) is a measurement of liquidity. It signals whether or not the company has enough assets to turn into cash to pay off upcoming liabilities. It is not a perfect signal, however.

Since most expenses and debt must be paid in cash, having positive WC shows that the company has the ability to pay off expenses and debt that will arise or come due in the short-term.

Buying Food: Most purchases, including food, must be made with a specific asset–cash. Not all current assets can be used to pay off expenses of debts.

WC, though, does not guarantee that a company can pay off all short-term expenses or liabilities. Simply having positive WC does not mean necessarily that a company will be able to pay off all expenses. Suppose that a company has current assets of \$100: \$20 of cash and \$80 of accounts receivable. They also have \$50 of current liabilities. That means that they have WC of +\$50. One of their accounts payable comes due tomorrow, so the company owes \$40. They have \$20 of cash on hand, but can’t get the other \$20 by tomorrow because they can’t collect \$20 of accounts receivable by tomorrow. The company cannot pay a short-term expense, even though a positive WC says that the company should be able to pay off most expenses and loans in the short-term.

WC is not a guarantee that the company will have enough cash for each expense, merely that they have operating liquidity.

## Controlling the Components of Working Capital

Working capital (WC) can be controlled by changing the levels of current assets and/or current liabilities through a number of mechanisms.

### Learning Objectives

Discuss how a company can adjust its working capital

### Key Takeaways

#### Key Points

• Increasing current assets or decreasing current liabilities increases WC, and vice versa.
• Four common mechanisms for controlling WC are cash management, inventory management, debtors management, and financing management.
• Having too little WC impairs a company’s ability to meet it’s financial obligations, while having too much WC can also be bad because it means that there are assets that are not being invested in the long-term.

#### Key Terms

• current liabilities: All liabilities of the business that are to be settled in cash within the fiscal year or the operating cycle of a given firm, whichever period is longer.
• Current Asset: An asset on the balance sheet, such as cash, accounts receivable, and inventory that is expected to be sold or otherwise used up in the near future, usually within one year or one business cycle, whichever is longer.

### Controlling the Components of Working Capital

Each company has different demands for how much Working Capital (WC) they need, but all companies prefer to have positive WC (recall that WC = current assets – current liabilities). Having too little WC impairs a company’s ability to meet it’s financial obligations. It is hard to pay expenses or debts that come due in the short-term. Having too much WC can also be bad because it means that there are assets that are not being invested. Holding too many short term assets slows future growth of the company. Thus, managing WC to an acceptable level is one of the most important jobs of management.

Walmart CFO: Charles Holley, the Chief Financial Officer (CFO) of Wal-Mart, is in charge of making sure all of Wal-Mart’s assets are allocated as optimally as possible.

WC can be adjusted by increasing or decreasing its two components: current assets (CA) and current liabilities (CL). Increasing CA or decreasing CL increases WC, and vis versa. Management can enact a number of policies, some of which are highlighted below:

• Cash management: Identify the cash balance that allows the business to meet day to day expenses, but reduces cash holding costs. Cash is a CA.
• Inventory management: Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials–and minimizes reordering costs–and hence increases cash flow. Inventory is a CA.
• Debtors management: Identify the appropriate credit policy, such as credit terms, that will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa). Credit extended to customers (accounts receivable) is a CA.
• Financing management: Identify the appropriate source of financing. Short-term financing (as well as long-term financing that comes due in the next year or operating cycle) is a CL.

By adjusting these four primary influencers on CA and CL, management can change WC to a desirable level.

## Importance of Working Capital

Working capital (WC) is a measurement of a company’s operating liquidity.

### Learning Objectives

Discuss why working capital is important to businesses

### Key Takeaways

#### Key Points

• WC is important for large companies’ ability to borrow, increase their share price, pay expenses and short-term debts.
• WC is important for small companies that cannot access financial markets to borrow, and for start-ups that need to survive until they break even.
• WC cannot guarantee whether a company is financially sound, but it gives some insight.

#### Key Terms

• operating liquidity: The ability of a company or individual to quickly convert assets to cash for the purpose of paying operating expenses.
• working capital: A financial metric that is a measure of current assets of a business that exceeds its liabilities and can be applied to its operation.

Working capital (WC) is an important metric for all businesses, regardless of their size. WC is a signal of a company’s operating liquidity. Having enough WC means that the company should be able to pay for all of its short-term expenses and liabilities.

Cash: Liquidity is a measurement of a company’s ability to quickly turn assets into cash.

Large companies pay attention to WC for the same reason as small ones do: WC is a measure of liquidity, and thus is a measure of their future credit-worthiness. Companies who want to borrow by issuing bonds or purchasing commercial paper (a market of large, short-term loans for big companies) will find it more expensive if they do not have enough WC. If they are a public company, their stock price may fall if the market doesn’t believe they have adequate WC.

For small businesses and start-ups, unable to access financial markets for borrowing, WC has more dire implications. WC can also be described as the amount of money that a small business or start-up needs to stay in operation. Start-ups need to pay attention to their WC because it is the amount of money they need to keep the business running until they break-even (start earning a net profit).

On one hand, WC is important to because it is a measure of a company’s ability to pay off short-term expenses or debts. On the other hand, too much working capital means that some assets are not being invested for the long-term, so they are not being put to good use in helping the company grow as much as possible.

WC is only one measure of a company’s operating liquidity. It is not the only measure, and it is certainly not a guarantee of a company’s ability to pay. A company may have positive WC, but not enough cash to pay an expense tomorrow. Similarly, a company may have negative WC, but may be able to adjust some of their debt into long-term debt in order to reduce their current liabilities.

WC is an important metric, but is not the whole story of a company’s financial health.

Source: Finance