How do you calculate working capital?

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

Working capital is the difference between current assets and current liabilities of a business. The challenge here is to determine the appropriate category for the wide range of assets and liabilities on a business balance sheet in order to decipher the overall health of a business and its ability to meet short-term commitments.

Components of working capital

Current assets

Short-term assets are assets that a company can easily turn into cash within a year or an economic cycle, whichever is shorter. They do not 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. Other examples include current assets from discontinued operations and accrued interest.

Current liabilities

Current liabilities are all debts and expenses that the company expects to pay within a year or an economic cycle, whichever is lower. This generally includes the normal costs of running the business such as rent, utilities, materials and supplies; interest or principal payments on debt; accounts payable; fees to pay ; and accrued income taxes.

Dividends payable, capital leases expiring in less than one year and long-term debt maturing are also current liabilities.

How to calculate working capital

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

You can calculate the current ratio by taking the current assets and dividing that number by the current liabilities. A ratio greater than 1 means that current assets exceed liabilities. Generally, the higher the ratio, the better the indicator of a company’s ability to pay short-term debts.

However, a very high current ratio (i.e. a large amount of available current assets) may indicate that a company is not using its excess cash as efficiently as it could to generate revenue. growth.

Working capital example: Coca-Cola

For the year ended December 31, 2017, The Coca-Cola Company (KO) had current assets valued at $36.54 billion. They included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventory, prepaid expenses and assets held for sale.

Coca-Cola also recorded current liabilities for the year ending December 2017 amounting to $27.19 billion. The company’s current liabilities included accounts payable, accrued liabilities, borrowings and notes payable, short-term maturities of long-term debt, accrued income taxes and liabilities held for sale.

Based on the information above, Coca-Cola’s current ratio is 1.34:

$36.54 billion ÷ $27.19 billion = 1.34

Does working capital change?

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

Working capital can change daily

The exact working capital figure can change daily, 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.

Likewise, what was once a long-term asset, such as real estate or equipment, suddenly becomes a short-term asset when a buyer comes in line.

Current assets can be written off

Working capital (as a current asset) cannot be depreciated like long-lived fixed assets. Some working capital, such as inventory, may decline in value or even be amortized, but this is not recorded as depreciation.

Working capital can only be expensed immediately as one-time costs for the revenue they help generate during the period.

Assets can be devalued

Although it cannot lose value due to depreciation over time, working capital can be devalued when certain assets need to be marked to market. This happens when the price of an asset is lower than its original cost and others are not salvageable. Two common examples relate to inventory and accounts receivable.

Inventory obsolescence can be a real problem in operations. When this happens, the inventory market has priced it at a lower price than the original purchase value of the inventory as recorded on the company’s books. In order to reflect current market conditions and to use the lowest cost and market method, a business reduces its inventory, which results in an impairment of working capital.

Accounts receivable can be written off

Meanwhile, some receivables may become uncollectible at some point and need to be written off entirely, representing another loss of working capital impairment.

Since such losses in current assets reduce working capital below the desired level, funds or longer-term assets may be required to replenish the current asset shortfall, which is an expensive way to finance additional working capital.

What does the current ratio indicate?

A healthy business has working capital and the ability to pay short-term bills. A current ratio greater than 1 indicates that a company has enough current assets to cover bills due in one year. The higher the ratio, the greater a company’s short-term liquidity and ability to pay its short-term liabilities and debt commitments.

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

A company with a ratio below 1 is considered risky by investors and creditors because it demonstrates that the company might not be able to cover its debts, if necessary. A current ratio of less than 1 is called negative working capital.

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

Special Considerations

A stricter liquidity ratio is the quick ratio, which measures the proportion of short-term liquidity to current liabilities. The difference between this ratio and the current ratio is in the numerator, where assets only include cash, marketable securities and receivables. The quick ratio excludes inventory, which may be more difficult to turn into cash in the short term.