Understanding Working Capital and Cash Flow for Financial Health

Working capital and cash flow are two metrics that finance teams need to understand if they want to determine whether their businesses can withstand an unanticipated downturn or crisis. These two metrics show various facets of an organization’s financial health.

Working capital is the difference between the company’s current assets, such as cash and other assets that can be converted into cash within a year, and its current liabilities, such as payroll, accounts payable, and accrued expenses. Cash flow measures how much money the company generates or consumes in a given period.

A company that maintains positive working capital will probably be better able to withstand financial difficulties and will have the freedom to invest in growth after fulfilling immediate obligations.

What Is Working Capital?

Current liabilities and current assets, as shown on the balance sheet of the company, are subtracted to get working capital. Cash, accounts receivable, and inventory are examples of current assets. Accounts Payable, Taxes, Wages, and Interest Owed are examples of Current Liabilities.

Working Capital Explained

The difference between a company’s current assets and current liabilities is known as its working capital. Working capital is a financial metric that aids in predicting future requirements and ensuring that the business has enough cash and cash equivalents to cover immediate obligations like unpaid taxes and short-term debt. 

Why Is Working Capital Important?

Working capital is used to fund operations and meet short-term financial obligations. Even if a company’s cash flow is constrained, it can continue to pay its employees and suppliers, as well as meet other obligations such as interest payments and taxes, if it has sufficient working capital.

Working capital can also be used to finance company expansion without taking on debt. If the business does need to borrow money, being able to show that it has a healthy working capital position may help it become more credit-worthy.

For finance teams, there are two main objectives: to have a clear understanding of the amount of cash on hand at any given time and to collaborate with the business to maintain enough working capital to cover liabilities while also allowing for growth and contingencies.

Advantages of Working Capital

Working capital can help smooth out revenue fluctuations. Many companies experience some seasonality in their sales, for example, selling more in some months than others. A company can prepare for busy months by making additional purchases from suppliers if it has enough working capital, and it can also pay its bills in lean times.

For instance, a retailer might make 70% of its sales in November and December, but it still needs to pay for expenses like rent and employee salaries throughout the entire year. The retailer can make sure it has enough money to stock up on supplies before November and hire temporary help for the busy season while making plans for how many permanent staff it can support by analyzing its working capital needs and maintaining an adequate buffer. 

The Balance Sheet and Working Capital

Current assets and current liabilities shown on a company’s balance sheet are used to calculate working capital. One of the three main financial statements that businesses produce, along with the income statement and cash flow statement, is the balance sheet.

A company’s balance sheet is a snapshot of its assets, liabilities, and shareholders’ equity at a specific point in time, such as the end of a quarter or fiscal year. All of a company’s short- and long-term assets and liabilities are listed on the balance sheet.

In order of liquidity, the balance sheet lists assets by category, starting with cash and cash equivalents. Additionally, it lists the liabilities by category, putting current liabilities first and long-term liabilities second.

How to Calculate Working Capital

As shown on the balance sheet, working capital is calculated as current assets minus current liabilities.

Working capital calculation formula

Working capital = current assets – current liabilities

Positive vs. Negative Working Capital

If a business has enough cash, accounts receivable, and other liquid assets to cover its short-term liabilities, including accounts payable and short-term debt, it has positive working capital.

In contrast, if a company doesn’t have enough current assets to cover its immediate financial obligations, it has negative working capital. A company with negative working capital might find it challenging to pay its creditors and suppliers, as well as to raise money to expand its operations. It might eventually have to shut down if the situation persists.

Elements Included in Working Capital

The following items are typically included in the current assets and liabilities used to calculate working capital:

Current Assets: Cash and other liquid assets that can be converted into cash within a year of the balance sheet date are considered current assets. Examples include:

• Cash, including funds in bank accounts and outstanding customer check deposits.
• Marketable securities include money market funds and US Treasury Bills.
• investments made in the short term that a company plans to sell within a year.
• Accounts receivable, minus any deductions for accounts with low chances of being paid.
• receivable notes with a one-year maturity date, such as short-term loans to clients or suppliers.
• Other receivables include things like insurance claims, employee cash advances, and tax refunds.
• Inventory including raw materials, work in progress, and finished goods.
• Prepaid expenses, like premiums for insurance.
• payments in advance for upcoming purchases.

All obligations that are due within a year of the balance sheet date are considered current obligations, Including: 

• Taxes payable.
• Accounts payable.
• Notes payable due within one year.
• Wages payable.
• Interest payable on loans.
• Any loan principal due within a year.
• Other payable accrued expenses.
• Deferred revenue, such as customer advance payments for goods or services not yet delivered.

How Working Capital Affects Cash Flow

In an accounting period, a company’s cash flow is the total amount of cash and cash equivalents coming in and going out. The company’s cash flow statement provides a summary of cash flow.

The amount of working capital a company needs depends on its cash flow. If revenue falls and the company experiences negative cash flow, it will deplete its working capital. Working capital may be reduced as a result of investments in higher production.

Working Capital vs. Net Working Capital

Working capital and net working capital are interchangeable terms that describe the difference between all current assets and liabilities.

However, compared to working capital, some analysts define net working capital more specifically.

One of these different calculations does not include cash and debt: 

Net working capital = current assets (less cash) – current liabilities (less debt)

Only accounts payable, accounts receivable, and inventory are included in an even more limited definition that leaves out the majority of asset types:

Net working capital = accounts receivable + inventory – accounts payable

Working Capital vs. Fixed Assets/Capital

Only current assets, which have a high level of liquidity and can be quickly converted into cash, are included in working capital. Fixed assets are not included in working capital because they are illiquid; that is, they cannot be easily converted to cash.

Real estate, buildings, machinery, and other tangible assets are examples of fixed assets. Intangible assets like patents and trademarks are also included.

What Is Working Capital Management?

Working capital management is a financial tactic that involves making the best use of working capital to pay for ongoing operational costs while ensuring the business makes productive use of its resources. The ability to fund operations costs and pay off short-term debt is made possible by good working capital management.

In order to evaluate the company’s working capital and associated factors, a number of financial ratios are frequently used in working capital management.

The ability of the business to fulfill short-term obligations is gauged by the working “capital ratio”, also referred to as the “current ratio”. It is determined by dividing current assets by current liabilities.

A company isn’t generating enough cash to pay down the debts due in the upcoming year if its working capital ratio is less than one. When a company’s working capital ratio is between 1.2 and 2.0, it is using its resources efficiently. Ratios higher than 2.0 suggest the company may not be utilizing its resources to their full potential; instead of reinvesting the money to increase revenue, it may be maintaining a sizable amount of short-term assets.

The working capital of a company is directly impacted by how effectively it manages its accounts receivable, as indicated by the average collection period. The ratio shows how long it typically takes to get paid after making a credit-based sale. It is determined by dividing the average total accounts receivable for a period by the total net credit sales, then multiplying the outcome by the number of days in the period.

The inventory turnover ratio shows how effectively a business manages its inventory to satisfy demand. By keeping track of this number, businesses can make sure they have the right amount of inventory on hand without investing excessive amounts of money in unsold inventory. 

The inventory turnover ratio indicates how many times inventory is sold and replenished during a specific period. It’s calculated as cost of goods sold (COGS) divided by the average value of inventory during the period. A higher ratio indicates inventory turns over more frequently.

Working Capital: The Quick Ratio and Current Ratio

The current ratio (working capital ratio) and the quick ratio, a related metric, are used by analysts and lenders to assess a company’s liquidity and capacity to meet short-term obligations.

These two ratios are helpful to lenders and investors because they can be used to compare a company’s current performance to previous quarters as well as to other businesses.

Quick Ratio

Working capital is only comprised of current assets, which have a high level of liquidity and can be turned into cash quickly. These are cash and equivalents, and accounts receivable, marketable securities.

Curent Ratio

The current ratio, on the other hand, takes into account all current assets, including those that might be difficult to convert into cash, like inventory.

Because of this, the quick ratio may provide a more accurate representation of the company’s capacity for quick cash raises.

Does Working Capital Change?

Working capital fluctuates frequently for the majority of businesses; the balance sheet provides a snapshot of its position on a particular date. The amount of working capital can be influenced by a variety of factors, such as significant outgoing expenses and seasonal sales fluctuations.

6 Ways to Increase Working Capital

A company might want to increase its working capital if, for instance, it needs to pay for project-related costs or encounters a brief decline in sales. There are two strategies to close that gap: increasing current assets or decreasing current liabilities.

Options include:

1. Taking on long-term debt. By increasing the company’s cash on hand, this raises current assets while barely raising current liabilities.
2. Refinancing short-term debt as longer-term debt. Due to the debts’ postponed annual due dates, this lowers current liabilities.
3. Selling illiquid assets for cash, thus increasing current assets.
4. Analyzing and reducing expenses, as well as lowering current liabilities.
5. Reduce overstocking and the possibility of having to write off inventory by analyzing and optimizing inventory management.
6. Automate the monitoring of payments and accounts receivable. As a result, there may be less need to use working capital for ongoing operations, increasing cash flow.

Accounting software can help you manage working capital, which is crucial for the health of your business. In order to invest in growth and fulfill immediate obligations, such as paying suppliers and loan interest, you must have positive working capital.

Negative working capital, on the other hand, is a red flag that a business may be struggling to stay afloat. An ERP with strong compliance management, however, improves business performance and increases financial close efficiency while lowering back-office costs, resolving delays, and producing statements and disclosures that meet regulatory requirements.

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