What is Working Capital?

When teaching Entrepreneurial Finance, I emphasized to my students that the important part of learning ratios isn’t just memorizing a formula, it’s understanding the meaning behind the ratio. It’s one thing to be able to regurgitate a formula on an exam, it’s another thing to be able to put it to use in real life. In this post, we’ll delve into the true meaning of the working capital ratio, its importance, and practical strategies for effective management.

Understanding Working Capital

Working capital provides a quick snapshot into the financial health of a company. It’s a very simple calculation: Current Assets (CA) – Current Liabilities (CL) = Working Capital (WC).

The working capital ratio is CA / CL = WC Ratio. The formula is easy to memorize, but can you use it in a sentence? As in:

“Managers and business owners must be able to manage their working capital on a daily basis in order to sustain their business.”

“The company was able to obtain a working capital line of credit to ensure they met their payroll deadlines.”

“The company’s healthy working capital position allowed it to weather the economic downturn without resorting to external financing or cutting back on essential operations.”

Illustration – Analyzing Working Capital

When a company’s current assets exceed its current liabilities, working capital is positive. Positive working capital and a high CA:CL ratio indicates that the company has sufficient resources to meet its short-term obligations and invest in its growth. It signifies financial strength, liquidity, and the ability to seize opportunities or navigate through challenging economic conditions.

Consider two companies, A and B.

Company A

Current Assets $1M – Current Liabilities $500,000 = $500,000

Current Assets $1M / Current Liabilities $500,000 = 2

Company B

Current Assets $5M – Current Liabilities $4,500,000 = $500,000

Current Assets $5M / Current Liabilities $4,500,000 = 1.1

Which company has a higher working capital? Although both have working capital of $500,000, Company B only has a 1.1 ratio whereas Company A has a ratio of 2. This means that Company A has twice the amount of available resources to pay its liabilities. Company B could liquidate all of its current assets and only have a relatively small amount left over after paying its short-term obligations. They’re cutting it close.

So the higher the working capital, the better, right? Well, that depends. At the outset, it may appear that Company A is in a better financial position, but Company B could be the winner.

Managing your working capital means that it’s neither too high nor too low. Company A has twice the amount required to pay its liabilities, but perhaps there is too much tied up in non-productive assets. Do they have a plan for their excess cash to invest in growing the business? (See our blog post on Striking the Right Balance of Cash.) Perhaps they are having trouble collecting their accounts receivables, which is also a non-productive asset. Managing inventory is key so they have enough on hand to satisfy customer demands but not too much to expose them to the risks of obsolescence and unnecessary storage costs.

While Company B appears to be in a risky position, perhaps it has a working capital line of credit that allows them to invest as much as they can in growth while protecting their risk with the ability to borrow money when needed. They may also have a “just-in-time” inventory process that allows them to minimize their inventory balances or favorable terms with their suppliers to be able to pay their liabilities over a longer period of time.

Ideal ratio

The ideal amount and ratio of working capital depends on the company’s strategy, growth plans, and ability to borrow.A good strategy for managing working capital is to ensure that you’re using your cash to invest in the future, collecting your receivables on time, maintaining an optimal inventory balance, and negotiating favorable terms with your suppliers.

“The company’s bottom line improved when they were able to improve their working capital management.”

Juna Financial Solutions is your partner in navigating financial statements. Contact us for a free consultation. info@junafinancial.com