Working Capital

Working capital is the difference between a business's current assets and its current liabilities, and it answers a narrow question: if everything the business expects to turn into cash within the next year came in, and everything it owes within the next year went out, what would be left? The SEC's guide to financial statements describes it as "the money leftover if a company paid its current liabilities (that is, its debts due within one-year of the date of the balance sheet) from its current assets." A positive figure means the near-term resources cover the near-term obligations with room to spare; a negative one means they do not, and the gap has to be closed by new revenue, by borrowing, or by stretching what is owed.

The definition is only as good as what "current" captures, and a balance sheet prepared to a standard format is explicit about it. SEC Regulation S-X, which governs the balance sheets public companies file, lists the current-asset line items in order: cash and cash items, marketable securities, accounts and notes receivable, inventories, prepaid expenses, other current assets, and then "Total current assets, when appropriate." The current-liability side runs accounts and notes payable, other current liabilities including accrued payrolls, accrued interest, taxes and the current portion of long-term debt, then "Total current liabilities, when appropriate." A small business's books do not have to follow that format, but the classification is the same idea, and the two totals are the only two numbers the calculation needs.

What the measure is bad at is worth knowing as well as what it is good at. It treats every current asset as equally available, and they are not. A dollar of cash and a dollar of slow-moving inventory both add a dollar to working capital, but only one of them pays a supplier this week. That is why the figure is usually read alongside its component parts, and often alongside the current ratio, which is the same comparison expressed as a quotient rather than a difference: current assets divided by current liabilities. A business with $180,000 of current assets and $120,000 of current liabilities has $60,000 of working capital and a current ratio of 1.5, and the two statements carry the same information in different units. The ratio travels better between businesses of different sizes; the dollar figure is more useful when the question is whether a specific bill can be paid.

The more revealing view is about timing rather than totals. The same balance-sheet figures can describe a comfortable business or a strained one depending on how quickly receivables turn into cash and inventory turns into sales, and how long the business has before it must pay its own suppliers. A business that collects in 20 days, holds inventory for 30 and pays its suppliers in 45 has all but five days of that 50-day cycle funded out of its suppliers' pockets. One that collects in 75 days, holds inventory for 60 and pays in 30 has to fund 105 days of operations before the first customer payment arrives, and it needs substantially more working capital to run the same volume of business. This is the reason working capital requirements grow when a business grows: more sales means more inventory bought and more invoices outstanding at any moment, and the cash for both goes out before it comes back. Growing quickly is a common way to run out of money while making a profit.

Negative working capital deserves the same care. In a business that sells for cash and pays suppliers on terms, a grocery chain or a restaurant, customers' money arrives before the suppliers' invoices are due, so the balance sheet shows more current liabilities than current assets as a matter of ordinary operation rather than distress. Elsewhere the same sign means something is wrong. What distinguishes them is not the number but the cycle underneath it, and the questions a lender asks when reviewing the figure are about that cycle: how old the receivables are, whether the inventory is moving, and how much of the current liabilities is trade credit in the normal course rather than debt that has come due.

1. Total the current assets. Cash and cash equivalents, marketable securities, accounts receivable, inventory, prepaid expenses, and anything else expected to convert to cash within a year.

2. Total the current liabilities. Accounts payable, accrued wages, accrued taxes and interest, and the portion of longer-term debt due within a year.

3. Subtract. Current assets minus current liabilities is working capital.

4. Read the components, not just the total. Cash and a slow-moving inventory both count, and they are not equally useful for paying a bill on Friday.

5. Compare it with the operating cycle. How long the business waits to be paid, and how long it has before it must pay, determines how much working capital the same volume of sales requires.

Take an example. A small equipment dealer's balance sheet shows $30,000 in cash, $65,000 of accounts receivable, $75,000 of inventory and $10,000 of prepaid insurance, so current assets total $30,000 + $65,000 + $75,000 + $10,000 = $180,000. It owes $70,000 to suppliers, $20,000 of accrued wages and payroll taxes, and $30,000 on the next twelve months of a term loan, so current liabilities total $120,000. Working capital is $180,000 − $120,000 = $60,000, and the current ratio is $180,000 ÷ $120,000 = 1.5. Now note what the $60,000 does not tell you: $75,000 of that cushion is inventory sitting on the floor. If it takes four months to sell and the $70,000 of supplier invoices is due in 30 days, the business has a timing problem that the positive figure conceals, and its $30,000 of cash plus whatever it collects on receivables in the next month is the number that matters.

Pros

• It is computed from two totals that any set of books already produces, so it costs nothing to track.
• It answers the question a small business most often gets wrong, which is whether it can pay its bills, not whether it is profitable.
• Watching it over time surfaces a growth squeeze early, because the figure tightens as sales rise before anything else in the accounts looks wrong.
• It is the language lenders use, so a business that tracks it is already speaking in the terms a credit application will be judged in.

Cons

• It counts every current asset as if it were cash, which overstates the cushion when inventory is slow or receivables are old.
• It is a snapshot on one date, and a business can look comfortable the day the statement is prepared and be short two weeks later.
• There is no universal benchmark, so the figure means little without the industry's operating cycle beside it.
• Negative working capital is a warning in one business model and ordinary in another, so the sign alone is not a diagnosis.