Definition
Working capital equals total current assets minus total current liabilities. A positive amount indicates that short-term resources exceed short-term obligations. Related measures are the current ratio (current assets divided by current liabilities) and the quick ratio, which excludes inventory and prepaids. Loan agreements often define working capital in their own way, for example excluding certain items or including undrawn lines, so the contract definition governs covenant tests.
Why it matters in an audit or review
Classification errors between current and noncurrent move working capital. Auditors use it in analytical procedures and in the going concern evaluation, where a deficit can indicate difficulty meeting obligations. Reclassifying debt in covenant violation can turn positive working capital negative.
Example
(Illustrative) Current assets are $1,800,000 and current liabilities are $1,200,000. Working capital is $600,000 and the current ratio is 1.5. If a $900,000 noncurrent loan in covenant violation becomes current, working capital becomes -$300,000 and the ratio is 0.86.
Common mistakes
- Using the textbook formula when the covenant defines it differently.
- Ignoring a deficit that results from reclassification.
Sources
- FASB ASC 210-10-45 (classification of current assets and current liabilities)
- FASB ASC 470-10-45 (classification of debt in covenant violation)
- AICPA, AU-C Section 570, The Auditor's Consideration of an Entity's Ability to Continue as a Going Concern
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error