Working capital: Overview, definition, and example
What is working capital?
Working capital refers to the difference between a business’s current assets (such as cash, accounts receivable, and inventory) and its current liabilities (such as accounts payable and short-term debt). It represents the company’s ability to cover its short-term obligations and fund day-to-day operations.
For example, if a business has $500,000 in current assets and $300,000 in current liabilities, its working capital is $200,000. Positive working capital indicates financial health, while negative working capital may signal liquidity problems.
Why is working capital important?
Working capital is important because it ensures a business can meet its short-term financial obligations, such as paying suppliers, covering payroll, and managing operating expenses. Strong working capital allows a company to invest in growth, handle unexpected costs, and maintain financial stability.
A company with insufficient working capital may struggle to operate efficiently, leading to cash flow issues, late payments, or the inability to take advantage of business opportunities. Effective working capital management helps businesses optimize cash flow and maintain financial resilience.
Understanding working capital through an example
Imagine a retail company with $1 million in inventory, $200,000 in cash, and $300,000 in accounts receivable. Its total current assets amount to $1.5 million. Meanwhile, the company has $700,000 in accounts payable and $300,000 in short-term debt, totaling $1 million in current liabilities. The working capital calculation would be:
$1.5 million (current assets) – $1 million (current liabilities) = $500,000 working capital
In another scenario, a manufacturing firm experiences a temporary cash shortage due to delayed customer payments. With negative working capital, the company struggles to pay suppliers on time, leading to production delays. To improve liquidity, the company secures a short-term loan or negotiates better payment terms with suppliers.
An example of a working capital clause
Here’s how a working capital clause might appear in a financial agreement:
“The Company agrees to maintain sufficient working capital to meet its ongoing financial obligations. If at any time the Company’s working capital falls below the required threshold, it shall take corrective measures, including securing additional financing or adjusting operating expenses.”
Conclusion
Working capital is a key measure of a business’s financial health, reflecting its ability to manage short-term obligations and sustain daily operations. Proper working capital management helps businesses maintain liquidity, avoid financial strain, and seize growth opportunities.
This article contains general legal information and does not contain legal advice. Cobrief is not a law firm or a substitute for an attorney or law firm. The law is complex and changes often. For legal advice, please ask a lawyer.