How Do You Calculate Working Capital?

Working capital represents a company’s ability to pay its current liabilities with its current assets. This figure gives investors an indication of the company’s short-term financial health, its capacity to clear its debts within a year, and its operational efficiency.

Components of Working Capital

Current Assets

Current assets are assets that a company can easily turn into cash within one year or one business cycle, whichever is less. They don’t include long-term or illiquid investments such as certain hedge funds, real estate, or collectibles.

Examples of current assets include:

• Checking and savings accounts
• Highly liquid marketable securities such as stocks, bonds, mutual funds, and exchange-traded funds (ETFs)
• Money market accounts
• Cash and cash equivalents
• Accounts receivable
• Inventory and other shorter-term prepaid expenses
• Current assets of discontinued operations and interest payable
  

Current Liabilities

Current liabilities are all the debts and expenses that the company expects to pay within a year or one business cycle, whichever is less. They typically include:

• Normal costs of running the business, such as rent, utilities, materials, and supplies
• Interest or principal payments on debt
• Accounts payable
• Accrued liabilities
• Accrued income taxes
• Dividends payable
• Capital leases that are due within a year
• Long-term debt that’s coming due

How to Calculate Working Capital

Working capital is calculated by subtracting current liabilities from current assets. Calculating the metric known as the current ratio can also be useful. The current ratio, also known as the working capital ratio, provides a quick view of a company’s financial health.

You can calculate the current ratio by taking current assets and dividing that figure by current liabilities. A ratio above one means that current assets exceed liabilities. Generally, the higher the ratio, the better an indicator of a company’s ability to pay short-term liabilities.

But a very high current ratio means a large amount of available current assets and may indicate that a company isn’t utilizing its excess cash as effectively as it could to generate growth.

Working Capital Example: Coca-Cola

The Coca-Cola Co. (KO) had current assets valued at $36.54 billion for the fiscal year ending Dec. 31, 2017. They included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.

Coca-Cola also registered current liabilities of $27.19 billion for that fiscal year. The company’s current liabilities consisted of accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale.

Coca-Cola’s current ratio was 1.34 based on this information:

$36.54 billion ÷ $27.19 billion = 1.34

Does Working Capital Change?

The amount of working capital does change over time because a company’s current liabilities and current assets are based on a rolling 12-month period, and they change over time.

Working Capital Can Change Daily

The exact working capital figure can change every day depending on the nature of a company’s debt. What was once a long-term liability, such as a 10-year loan, becomes a current liability in the ninth year, when the repayment deadline is less than a year away.

What was once a long-term asset, such as real estate or equipment, can suddenly become a current asset when a buyer is lined up.

Current Assets Can Be Written Off

Working capital can’t be depreciated as a current asset the way long-term, fixed assets are. Certain working capital such as inventory can lose value or even be written off, but that isn’t recorded as depreciation.

Assets Can Be Devalued

Working capital can’t lose its value to depreciation over time, but it may be devalued when some assets have to be marked to market. This can happen when an asset’s price is below its original cost and others aren’t salvageable. Two common examples involve inventory and accounts receivable.

Inventory obsolescence can be a real issue in operations. The market for the inventory has priced it lower than the inventory’s initial purchase value as recorded in a company’s books. A company marks the inventory down to reflect current market conditions and uses the lower of cost or market method, resulting in a loss of value in working capital.

Accounts Receivable May Be Written Off

Some accounts receivable may become uncollectible at some point and have to be totally written off, representing another loss of value in working capital. It may take longer-term funds or assets to replenish the current asset shortfall because such losses in current assets reduce working capital below its desired level. This is a costly way to finance additional working capital.

Unearned revenue from payments received before the product is provided will also reduce working capital. This revenue is considered a liability until the products are shipped to the client.

What Does the Current Ratio Indicate?

A healthy business has working capital and the ability to pay its short-term bills. A current ratio of more than one indicates that a company has enough current assets to cover bills that are coming due within a year. The higher the ratio, the greater a company’s short-term liquidity and its ability to pay its short-term liabilities and debt commitments.

A higher ratio also means that the company can continue to fund its day-to-day operations. The more working capital a company has, the less likely it is to take on debt to fund the growth of its business.

A company with a ratio of less than one is considered risky by investors and creditors because it demonstrates that the company might not be able to cover its debts if needed. A current ratio of less than one is known as negative working capital. 

We can see in the chart below that Coca-Cola’s working capital, as shown by the current ratio, has improved steadily over a few years. This indicates improving short-term financial health.

Special Considerations

A more stringent liquidity ratio is the quick ratio. This measures the proportion of short-term liquidity compared to current liabilities. The difference between this and the current ratio is in the numerator where the asset side includes only cash, marketable securities, and receivables. The quick ratio excludes inventory because it can be more difficult to turn into cash on a short-term basis.

The Bottom Line

Working capital is the difference between a company’s current assets and current liabilities. The challenge here is determining the proper category for the vast array of assets and liabilities on a corporate balance sheet to decipher the overall health of a company and its ability to meet its short-term commitments.