Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity - including a governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques, such as DCFs (Discounted Cash Flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a "working capital deficit. "
A company can be endowed with assets and profitability but short on liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
Calculation
Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:
- accounts receivable (current asset)
- inventory (current assets)
- accounts payable (current liability)
Therefore, in this context, we calculate available working capital using the following formula:
Working Capital Equation
Working capital is equal to accounts receivable, plus current inventory, minus accounts payable.
These values can be readily found on a company's balance sheet. The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.
As an example, imagine a company has accounts receivable of $10,000, current inventory that has a value of $5,000, and accounts payable of $7,000. We can find working capital by:
Working Capital = $10,000 + $5,000 - $7,000 = $8,000
An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities, for example, has paid off some short-term creditors.
Implications on M&A
The common commercial definition of working capital for the purpose of a working capital adjustment in a mergers and acquisitions transaction (i.e., for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:
Current Assets - Current liabilities (excluding deferred tax assets/liabilities, excess cash, surplus assets, and/or deposit balances).
Cash balance items often attract a one-for-one purchase-price adjustment.