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Working capital is one of the most important indicators of a company’s financial health. It reflects whether the business can meet its short-term obligations and support ongoing operations.
While the formula is simple – current assets minus current liabilities – the real insight lies in how working capital connects to cash flow, performance metrics, and the Cash Conversion Cycle (CCC).
Strong working capital management ensures a company can convert inventory and receivables into cash while paying suppliers efficiently. The CCC highlights how quickly this conversion happens, showing whether capital is tied up too long in operations or working efficiently to support growth.
In this article, we’ll explain what working capital is, break down its components, and explore how it influences cash flow, liquidity, and profitability.
We’ll also cover why monitoring key working capital metrics and the CCC is essential, and why looking beyond accounting definitions to Operating Working Capital provides a more practical view of business efficiency.
Become a Certified Working Capital Expert with our accredited course Managing Working Capital
Working Capital, also referred to as Net Working Capital (NWC), represents the capital a company has available to meet its short-term financial obligations.
It is defined as the difference between a company’s current assets and current liabilities, as listed on the company’s balance sheet.
Working Capital = Current Assets − Current Liabilities
The working capital financial metric tells if a company holds sufficient cash and cash equivalents to pay its short-term financial obligations. Cash equivalents, such as inventory and customer credits, are items that are expected to convert into cash within one operating cycle, often one year.
All working capital components can be found on a company’s balance sheet, under current assets and current liabilities.
Current assets refer to shorter-term assets that a company owns, benefits from, or uses to generate income from.
These assets are considered current as they are expected to be consumed or converted into cash within an operating cycle – most often within a year.
These assets are used to facilitate day-to-day operational activities and expenses, and include the company’s cash, inventories, accounts receivable, pre-paid expenses and other current assets:
Current liabilities refer to short-term obligations and debt that a company carries to finance its assets.
These liabilities are classified as current because they are expected to be settled within an operating cycle, typically within one year.
Current liabilities include items such as accounts payable, unearned revenue, wages payable, the current portion of long-term debt, unpaid taxes, and other short-term debt due within one year:
Working capital management is about ensuring a company is utilizing its current assets and current liabilities as effectively as possible.
In brief, the hallmark of strong business practices is the ability to manage its working capital in a way in which it allows the company to maintain a solid balance between liquidity, growth and profitability.
Note that to manage its strategic and operational perspectives, a company must look to its operating working capital. You can read more on this under section Limitations of the working capital metric below.
Without generating sufficient available cash, a company will struggle to perform routine activities such as purchasing goods and services, paying employee salaries, making investments, financing growth, or servicing debt.
Cash flow is directly influenced by the company’s ability to convert working capital assets into sales and customer payments.
This is because items such as unsold inventory and unpaid customer invoices represent cash tied up in operations.
Let’s look at an example to illustrate this:
In business management and financial analysis, working capital is a critical metric. It reflects a company’s financial health, operational efficiency, growth readiness, and ability to meet short-term obligations.
Working capital requirements vary across industries and can even differ between similar companies.
Several factors drive this variation, including regional differences in commercial terms, collection and payment policies, timing and lead times for purchases and production, and the need to maintain inventory.
However, what remains common is that companies must ensure they can meet their short-term financial obligations.
When a company has more short-term debt than short-term assets, it may face challenges in covering payrolls or paying suppliers each month.
Many companies track their Working Capital Ratio (also called the current ratio) to monitor liquidity.
Working capital ratio = current assets / current liabilities
The current ratio helps illustrate how much of a company’s revenues will be used to meet payment obligations in the period.
And, consequently, it shows how much cash the company will have left for new opportunities such as financing growth or capital investments.
Working capital requirements are different between industries and can even vary between similar companies.
This is driven by several factors, such as a company’s level of indebtedness, differences in collection and payment policies, regional variations in commercial terms, the timing and lead-time of purchases and production, requirements to keep inventory, etc.
However, the working capital ratio is by itself not a complete representation of a company’s short-term liquidity or longer-term solvency, as it at any time only provides a snapshot of performance.
Also, it does not consider the quality of current assets and includes items that may not be easily converted into cash, such as slow moving or obsolete inventories.
It is therefore important to use the working capital ratio as one of several indicators of a company’s liquidity and financial health.
As described earlier, not all current assets are easily converted into cash. It can however be challenging to identify performance gaps and risks related to a company’s core operating activities by looking at the working capital metric alone.
This is because it includes a mix of both financial and operational elements.
To be able to read into the quality of the operational elements alone, many companies turn to their operating working capital (also referred to as trade working capital).
This metric includes only items within a company’s core operational control and represents the capital a company carries and must finance to support its day-to-day operations.
Improving the working capital involves managing your current assets and liabilities more effectively to ensure you have enough liquidity to cover short-term obligations. Here are some strategies to improve your working capital:
By implementing the above strategies, a company will improve its working capital and strengthen its financial position, ultimately enhancing its ability to meet short-term obligations and support long-term growth.
Working capital is far more than a line item on the balance sheet – it is a vital indicator of a company’s liquidity, efficiency, and financial health.
By understanding its components, monitoring key ratios, and recognizing its impact on cash flow and the cash conversion cycle, businesses can identify risks early and unlock opportunities for growth.
Strong working capital management means finding the right balance: enough liquidity to cover obligations, but not so much idle capital that resources go underutilized.
Ultimately, mastering working capital equips companies with the agility to sustain operations, fund growth, and strengthen long-term profitability.
Turn theory into practice and boost your career with accredited training. Become a Certified Working Capital Expert by enrolling in our flagship course: Managing Working Capital.
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