Working capital and what it tells you
Working capital is current assets minus current liabilities. The split between current and non-current comes from the classified balance sheet (ASC 210-10-45): an asset is current if it will be realized or consumed within a year or the operating cycle, a liability is current if it is due in that time. Because the figure depends on classification, a covenant breach that turns long-term debt into current debt can swing working capital sharply without any change in cash.
Two other views are included. Operating working capital leaves out cash and short-term debt, so it isolates the receivables, inventory and payables that move with sales; its change from one year to the next is roughly the cash the business absorbed or released in operations. The cash conversion cycle (days sales outstanding plus days inventory minus days payable) says how long cash is tied up. This page uses closing balances; the financial ratio calculator uses averages. Auditors compare these measures year to year as analytical procedures and use them in the going concern evaluation under AU-C 570.
Common questions
What is the working capital formula?
Working capital = current assets − current liabilities. Operating working capital = (current assets − cash) − (current liabilities − short-term debt), which isolates the operating items.
What is a good working capital ratio?
It depends on the industry and the lender. Covenants sometimes set a minimum current ratio, at a level fixed in each agreement, and a retailer with fast inventory turns or a subscription business with deferred revenue can often run lower safely. Compare to the entity's own history and peers.
Is negative working capital always bad?
No. Businesses that collect before they deliver, such as subscription or prepaid services, often have negative working capital because deferred revenue is a current liability. Elsewhere it is a liquidity warning to evaluate for going concern.
What is the cash conversion cycle?
Days sales outstanding plus days inventory outstanding minus days payable outstanding. It measures the days between paying suppliers and collecting from customers. A longer cycle ties up more cash.
How does a working capital change affect cash flow?
An increase in operating working capital uses cash; a decrease releases it. In an indirect-method cash flow statement the individual changes in receivables, inventory and payables are adjustments to net income.
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