Thursday, 3 August 2017

Investopedia/Ryan C. Fuhrmann: How do you calculate working capital?

How do you calculate working capital? By Ryan C. Fuhrmann, CFA | Updated April 9, 2017 — 9:21 PM EDT


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

Current assets represent assets that a firm expects to turn into cash within one year, or one business cycle, whichever is less. More obvious categories include cash, cash and cash equivalents, accounts receivables, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable. For the fiscal year ended December 31, 2016, the balance sheet of The Coca-Cola Company (KO) showed that the company's total current assets valued at $34.01 billion included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.

Current Liabilities

In similar fashion, current liabilities are liabilities that a firm expects to pay within a year, or one business cycle, whichever is less. Examples include accounts payables, accrued liabilities, and accrued income taxes. Other current 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 (KO) had current liabilities that comprised of accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale for the fiscal year ended December 2016. The value of the total current liabilities equaled $26.53 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 health at a firm. A ratio above 1 means current assets exceed liabilities, and the higher the ratio, the better. Using the information provided about KO above, the company's current ratio is:

$34.01 billion ÷ $26.53 billion = 1.28

A more stringent ratio is the quick ratio, which measures the proportion of short-term liquidity as compared to current liabilities. The difference between this and the current ratio is in the numerator, where the asset side includes cash, marketable securities, 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 health of a firm. The quick ratio is an even better indicator of shorter-term liquidity and can be important for suppliers and lenders to understand as well as for investors to assess how a company can handle short-term obligations.

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