What is Working Capital, Anyway?

Definition of Working Capital

The CFA Institute defines working capital as:

“the short-term investment and financing requirements of a company”

In other words, working capital is the capital (i.e. cash and other current assets) that is immediately available to a company for the operation of its day to day business.

Working Capital is expressed numerically as Current Assets less Current Liabilities or, as a ratio, Current Assets / Current Liabilities.

Current Assets typically comprise Cash, Short Term Investments, Accounts Receivable and Inventories (ie stock on hand). Current Liabilities usually comprise Short Term loans and Borrowings, Accounts Payable, and other liabilities such as employee entitlements.

A positive Working Capital figure or ratio indicates that the company has sufficient capital to meet its short term operating requirements, whereas a negative figure or ratio indicates that the company has a short term shortfall.

A Working Capital ratio between 1.2 and 2.0 is generally considered acceptable.

The significance of Working Capital

Negative working capital indicates that a company has a short term capital shortfall and needs to source of borrow additional funds to meet its commitments. Additionally, negative or low working capital prevents a company from investing in growth initiatives, such as purchasing additional stock during a busy season or pursuing an acquisition opportunity.

Conversely, a positive working capital indicates that the company has sufficient capital to meet its commitments. However, an excess of working capital can be inefficient, as capital is tied up in unproductive assets such as cash or accounts receivables.

Managing your Working Capital

Managing Working Capital is a balancing act between holding too much and too little short term capital.  In broad terms, the objective of Working Capital management is to achieve the right balance of cash flow through the business by:

Assets

  • Maintaining an appropriate level of cash or financing facilities, i.e. managing liquidity
  • Minimising the levels of inventories on hand
  • Minimising accounts receivable outstanding

Liabilities

  • Maximising accounts payable terms
  • Maintaining appropriate short term borrowings and financing facilities to meet cash commitments

In order to properly manage working capital, a number of management processes must work together:

  • Accurate and timely measurement and reporting of the key variables which affect the overall level of Working Capital
  • A cash management strategy (both in terms of investment of idle cash and financing facilities to provide cash as needed
  • Strategies to manage accounts receivable and accounts payable outstandings
  • Inventory management systems (for example “Just in Time” and “Manufacturing Resource Planning”) to ensure an appropriate level of inventory is held to meet demand, without over-investment

The combination of these processes should ensure capital is available to allow a business to meet its commitments with the flexibility needed to take advantage of opportunities as they arise, and without over-investing in unproductive assets.