Working capital is a financial metric which represents operating liquidity available to a business, organization or other entities, including a governmental institution. Along with fixed assets such as plant and equipment, working capital is considered a part of in operation of capital. Gross working capital has to equal to current assets. Working capital is calculated by taking the current assets and subtracting them from current liabilities. If the current assets are less than the current liabilities, an entity has a working capital deficiency.
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.
Current assets represent assets that a firm expects to turn into cash within one year, or in one business cycle. Which ever you find to be less. Some of the more obvious categories include cash, accounts receivables, cash and cash equivalents, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable. For the fiscal year of 2016, the balance sheet of The Coca-Cola Company showed that the company’s total current assets valued at $34 billion included marketable securities, short-term investments, inventories, accounts receivable, prepaid expenses, cash and cash equivalents.
In similar fashion, current liabilities are liabilities that a firm expects to pay within a year, or in one business cycle. Again, whichever you find to be less. Examples include accounts payables, accrued liabilities, and accrued income taxes. Other liabilities include dividends payable, capital leases due within a year, and long-term debt that is now due within the year. The Coca-Cola Company had current liabilities that comprised of accounts payable, loans and notes payable, accrued expenses, current maturities of long-term debt, accrued income taxes, and liabilities held for sale for the fiscal year ended in 2016. The value of the total current liabilities were just over $26 billion.
What Working Capital Means
A healthy business will have ample capacity to pay off its current liabilities with current assets. The current ratio is current assets divided by current liabilities and provides insight into working capital at a firm. When a ratio is above one it means current assets exceed liabilities, and the higher the ratio, the better. Using the information provided about Coca-Cola above, the company’s current ratio is:
$34 billion ÷ $26 billion = 1.38
A more stringent ratio is the quick ratio, which measures the proportion of short-term liquidity as compared to current liabilities. The difference between quick ratio and the current ratio is in the numerator, where the asset side includes marketable securities, cash, and receivables. The key item it excludes is inventory, which can be more difficult to turn into cash on a shorter-term basis.
The Bottom Line
The formula for calculating working capital is straightforward, but lends great insight into the shorter-term of a firm. The quick ratio is a better indicator of shorter-term liquidity and can be important for lenders and suppliers to understand as well as for investors to assess how a company can handle short-term obligations.
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