Working capital allows companies to calculate the operating liquidity of their business, by measuring the number of expenses they generate compared to their current assets. This metric shows how a company is paying off its obligations in a period (for example 3 months or one year) or business cycle.
In other words:
- Working capital is the money used to cover all of a company's short-term expenses, including inventory, payments on short-term debt, and day-to-day expenses—called operating expenses.
- Working capital is the money that companies use to operate and conduct their organizations.
How Does Working Capital Work?
Working capital is the cash that companies use to operate and conduct their operations. Effective working capital management ensures that a company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
The right balance is important: if a company has insufficient cash to pay for its current expenses, it may have to file for bankruptcy, sell off assets, reorganize, or liquidate. Conversely, accumulating too much cash and liquid assets is not an efficient way for a company to manage its resources.
Working capital ratio = Current assets / Current liabilities
If the working capital of your company is less than 1, it can indicate potential future liquidity problems. When your business’ working capital ratio is between 1.5 and 2, it means that your company has more current assets than liabilities and is an indicator of stable financial ground in terms of liquidity. A ratio higher than 2 is not necessarily better, as it might mean your company’s assets aren’t being leveraged to grow your business.
An important measure of your company’s working capital is your cash conversion cycle (CCC), which measures the number of days it takes your company to:
- convert inventory to sales (Days Inventory Outstanding [DIO]) and
- receive payment for sales (Days Sales Outstanding [DSO]),
and then subtracts the number of days it takes to:
- pay your vendors for supplies (Days Payable Outstanding [DPO]).
Ideally, companies want to have a shorter cash conversion cycle to demonstrate healthy revenue against expenses (most Fortune 500 companies aim at reaching negative CCC). You can reduce your cash conversion cycle by selling inventory more efficiently, increasing speed of customer payment, and adjusting the timing of your vendor payments. Increasing your liquidity by reducing your CCC can allow you to have more working capital available to invest directly into your business.