Working Capital

Working capital (also called net working capital) equals the amount by which a company’s current assets exceed its current liabilities.

Working capital is a measure of a company’s liquidity. A positive working capital tells us that the sources of a company’s cash over the next one year exceed the obligations that it must satisfy over the same period. A negative working capital means that the obligations due to be paid within one year exceed the assets due to be realized within the same period. A negative working capital represents a liquidity crunch.

Net operating working capital (NOWC) is a related measure which determines the difference between operating current assets and operating current liabilities. In other words, it excluded non-operating assets and liabilities such as investments, etc.

Formula

Net working capital (NWC) is calculated using the following formula:

Net Working Capital (NWC) = Current Assets − Current Liabilities

Current assets are assets that are expected to be converted to cash within one operating cycle or 12 months. These include cash, short-term investments, receivables, inventories, etc.

Current liabilities are claims against a company which must be settled within one operating cycle or 12 months. These include accounts payable, current portion of borrowings, taxes payable, accrued expenses, etc.

Analysis

Just like any other ratio, a company’s working capital must be analyzed in the context of its industry and in comparison with its peers. While the amount of difference between current assets and current liabilities is important, it is often more useful to compare their ratio which is determined by calculating the current ratio (which is also sometimes called the working capital ratio).

Even though a healthy working capital is necessary for a company’s liquidity, it ought not be too high because typically return on current assets is far lower than return on long-term assets. The efficiency with which a company uses its working capital is often gauged using the working capital turnover.

Examples

  1. Company A has current assets of USD 5 million and current liabilities of USD 3 million. Its working capital is USD 2 million (USD 5 million minus USD 3 million).
  2. Company B has a current ratio of 1.5 and its current liabilities are USD 80 million. Since the current ratio is equal to current assets divided by current liabilities. we can calculate current assets by multiplying current ratio with current liabilities (USD 80 million × 1.5 = USD 120 million). Current liabilities are USD 80 million hence working capital is USD 120 million minus USD 80 million which is USD 40 million.

by Obaidullah Jan, ACA, CFA and last modified on
Studying for CFA® Program? Access notes and question bank for CFA® Level 1 authored by me at AlphaBetaPrep.com

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