Working Capital

Working Capital Definition

Working capital, also sometimes referred to as net working capital, is the difference between current assets and current liabilities. Working capital measures the immediate liquidity of the business, or the ability of a company to pay its short-term obligations.

Working Capital Formula

Current Assets – Current Liabilities = Working Capital

The working capital calculation is similar to the accounting equation that can be rearranged to determine the amount of assets that belong to the owner debt-free, or the net worth of the business.

Main Accounting Equation

Assets – Liabilities = Owner’s Equity

The difference is that the working capital calculation measures current assets that can be converted to cash against current debts that may be coming due. It therefore provides a comfort level of available resources to pay current liabilities. A negative working capital result indicates a company may have trouble paying debts, and may be at risk of bankruptcy.

Net working capital is more relevant when compared with previous quarters or years. Declining figures may indicate a decline in sales, and thus a decline in cash or accounts receivable.

However, an increase in net working capital may indicate operating inefficiency. Increasing cash balances may indicate the company has not utilized cash effectively for growth. Increasing inventories may indicate slow inventory turnover and an inefficient use of cash tied up in inventory.

Decreasing accounts receivable turnover may indicate that more customers are not paying amounts due on time, which reduces the ability to pay debts due.

For these reasons, it is important that net working capital results are compared with past figures for the company. To view the balance sheet analysis for Sunny Sunglasses Shop, click balance sheet analysis.

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