Working capital represents a company’s ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since creditors can measure a company’s ability to pay off its debts in the short term or less than one year.
Working capital represents the difference between a firm’s current assets and current liabilities. The challenge can be determining the proper category for the vast array of assets and liabilities on a firms’ balance sheet and deciphering the overall health of a firm in meeting its short-term commitments.
Components Of Working Capital
Current assets represent assets that a firm expects to turn into cash within one year, or one business cycle, whichever is less. More obvious categories include cash, cash and cash equivalents, accounts receivables, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable.
In similar fashion, current liabilities are liabilities that a firm expects to pay within a year, or one business cycle, whichever is less. Examples include accounts payables, accrued liabilities, and accrued income taxes. Other current liabilities include dividends payable, capital leases due within a year, and long-term debt that is now due within the year.
Working capital is calculated by using the current ratio. The current ratio is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and the higher the ratio, the better.
Working Capital Example: Coca-Cola
The Coca-Cola Company (KO) had current assets for the fiscal year ending December 31, 2017, valued at $36.54 billion. The current assets included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.
Coca-Cola had current liabilities for the fiscal year ending December 2017 equaling $27.19 billion. The current liabilities included accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale.
Using the information provided about KO above, the company’s current ratio is:
$36.54 billion ÷ $27.19 billion = 1.34
What Working Capital Means
- A healthy business will have ample capacity to pay off its current liabilities with current assets. A higher ratio or above 1 means a company’s assets can be converted into cash at a faster rate. As a result, the more likely a company can pay off its short-term liabilities and debt.
- A higher ratio also means the company can easily fund its day-to-day operations. The more working capital a company has means that it may not have to take on debt to fund the growth of its businesses.
- A company with a ratio of less than 1 is considered risky by investors and creditors since it demonstrates that the company may not be able to cover its debt if needed. A current ratio of less than 1 is known as negative working capital. For more on the different types of working capital please read Can Working Capital Be Negative?
We can see in the chart below that Coco-Cola’s working capital, as shown by the current ratio, has improved steadily over the last few years.
A more stringent ratio is the quick ratio, which measures the proportion of short-term liquidity as compared to current liabilities. The difference between this and the current ratio is in the numerator, where the asset side includes cash, marketable securities, and receivables. The quick ratio excludes inventory, which can be more difficult to turn into cash on a short-term basis.
The Bottom Line
The formula for calculating working capital is straightforward, but lends great insight into the short-term financial health of a company. The quick ratio is an even better indicator of shorter-term liquidity and can be important for suppliers and lenders to understand as well as for investors to assess how a company can handle short-term obligations.