Working capital is a term that financial folks toss around, but its meaning may not be clear to others. Textbooks refer to working capital as the difference between current assets and current liabilities. Current assets are those that will probably convert to cash within one year. Current liabilities are those that will have to be paid within one year. Cash, accounts receivable, inventory and prepaid expenses are common current assets. Current liabilities include payables to suppliers, payroll liabilities, the next 12 months on principal payments due on loans and capital leases and taxes that are due within one year.
Many financial institutions and analysts look at the working capital ratio (current assets divided by current liabilities) as a measure of short term liquidity. If liabilities are high in relation to current assets, the firm doesn’t have as much short term liquidity.
Another ratio that is computed is the quick ratio. It compares cash and accounts receivable to current liabilities. This is a tighter ratio than the working capital ratio but it acknowledges that some current assets will not convert to cash quickly but most liabilities have to be paid when due. The largest component that is excluded in the quick ratio is inventory on the basis that some items may require a markdown to move quickly.
These measures of liquidity are flags but don’t really serve the business owner because the past is not always an accurate projection of the future.
I prefer to look at the components of the ratios. Rolling forward receivables with realistic sales assumptions that encompass the mix of customers and their payment habits should be a better indication of the investment the owner needs to make. Looking at sales expectations will also create a window into inventory and purchasing: what will be needed, when will it be needed to meet customer demands, who will supply it, what delivery methods will be used and when will vendors require payment. Will volume changes impact the purchase price for the goods or the utilization of staff?
When these variable activities are coupled with known fixed expenses, the business can anticipate their working capital requirements. This knowledge allows the owner to adjust other cash demands and approach their bankers with well thought out projections.