Working capital is a measure of the operating liquidity of a business, organization or other entity. It is the capital of a business that is utilized in its day-to-day trading operations.
It is the difference between current liabilities and current assets.
Of all assets, current assets are the most liquid, i.e. that they can easily be converted to cash. Current liabilities are financial obligations that are due to be paid within a year.
Working capital represents what remains after subtracting current liabilities from current assets. It can either be a positive or negative amount.
Working capital is a measure of a company’s liquidity, efficiency and general health.
It represents an entity’s margin of protection to pay short-term creditors.
Working capital ratio
This is calculated by dividing Current Assets by Current Liabilities. Anything below 1 indicates negative working capital while anything over 2 suggests that the company is not investing excess assets. The majority of economists believe that the ideal ratio is between 1.2 and 2.0.
A healthy company should have a positive working capital, while a negative one is a sign of severe cash flow problems. If current liabilities are more than current assets then the entity has a working capital deficiency, also called a working capital deficit.
A positive working capital cycle minimizes net working capital and maximizes free cash flow by balancing incoming and outgoing payments.
Businesses that are cyclical generally need to build up more working capital to remain afloat during the off season, to make sure they have enough ready money to meet their short-term obligations. Examples of seasonal businesses include ski resorts, gardening services, hotels, summer camps, selling Easter eggs, and aviation.
Difference between working capital and cash flow
Working capital provides a snapshot of the company’s current situation, while cash flow measures its ability to generate money (cash) over a specific period.
A business’ quarterly cash flow will be different from its annual cash flow.
Working capital is better at telling us how well a company can pay off immediate debts (liabilities). Cash flow, on the other hand, is forward-looking
A company might have insufficient working capital but adequate cash flow, i.e. given enough time it could generate enough cash. However, if creditors cannot wait, the business could be in trouble.
Video – Definition of Working Capital