Definition: Working capital, also called net working capital, is a liquidity ratio that measures a company’s ability to pay off its current liabilities with its current assets. Working capital is calculated by subtracting current liabilities from current assets.
What Does Working Capital Mean?
Working capital is an important concept for creditors because it shows how well companies can pay off their current obligations without depleting any of their long-term assets. In other words, creditors want to see that companies can produce enough income, cash, and receivables to pay for current obligations as they come due. This shows how liquid the company is.
If companies can’t pay off their current liabilities with current assets, they will have to sell off long-term assets. By selling these revenue generating long-term assets, the company decreases future possibilities of revenue. Obviously, creditors are concerned with not only a company’s ability to meet current obligations but also the company’s long-term sustainable and growth. Companies that sell long-term assets to pay for current obligations instead of using working capital is a sign that the company’s operations are failing.
Companies with sufficient amounts of working capital can carry inventory, take advantage of cash discounts, and finance current acquisitions with current liabilities.
For instance, a manufacturer that has current liabilities of $100,000 and current assets of $200,000 has working capital of $100,000. This means that after all the current liabilities are paid off the company still has $100,000 of current assets remaining. This manufacturer is highly liquid.
When analyzing a company’s working capital, it is important to look at its total working capital dollars as well as its current ratio.