Working capital is a basic accounting formula companies use to determine their short-term financial health. The basic formula is current assets minus current liabilities. Changes in working capital will occur when either of these two items increase or decrease in value. Both current assets and current liabilities are found on a company’s balance sheet. Each group represents items owned for business use or obligation to pay for services and goods, respectively. Significant changes — whether positive or negative — in working capital can send mixed signals to internal and external business stakeholders.
Current assets include cash and cash equivalents, inventory, accounts receivable, and notes receivable. These items include assets a company will use in fewer than 12 months in its business operations. In order for working capital to change, one of these items will need to increase or decrease. Accounting transactions can involve two or more of these accounts, which will have no effect on the working capital formula. For example, an asset exchange transaction occurs when a company collects cash for previous sales on account. This increases cash while decreasing accounts receivable.
Current liabilities include accounts payable, trade credit, short-terms loans, and credit lines. Similar to current assets, these companies must pay off these financial obligations in less than 12 months. Asset exchange transactions do not generally occur in current liabilities. Changes in working capital will occur when these items increase or decrease. To decrease current liabilities, companies will generally use cash from their current assets, so working capital won't change since both current assets and current liabilities will decrease in tandem. Companies that pay off current liabilities by refinancing loans or using a credit line to pay off an accounts payable balance will change their working capital balance.
Working capital is an important concept in business because all companies must have cash in order to pay for expenses relating to business operations. Banks, lenders, and investors look at this figure and the resulting changes in working capital to assess a company’s financial health. Companies with wide swings from positive to negative working capital can tip off lenders and investors about the company’s business practices. The failure to generate sufficient capital from accounts receivable is a common problem. Companies will sell goods on account, but face difficulties collecting outstanding balances. This results in large uncollectable balances that will lower the company’s working capital. It also means companies must find other ways to generate cash to pay for short-term financial needs.