How Do You Calculate Working Capital?

Working capital represents a company's ability to pay its current liabilities with its current assets. Working capital is an important measure of financial health since creditors can measure a company's ability to pay off its debts within a year.

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 corporate balance sheet and deciphering the overall health of a firm in meeting its short-term commitments.

Current Assets

This is what a company currently owns—both tangible and intangible—that it can easily turn into cash within one year or one business cycle, whichever is less. More obvious categories include checking and savings accounts; highly liquid marketable securities such as stocks, bonds, mutual funds and ETFs; money market accounts; cash and cash equivalents, accounts receivable, inventory, and other shorter-term prepaid expenses. Other examples include current assets of discontinued operations and interest payable. Current assets do not include long-term or illiquid investments such as certain hedge funds, real estate, or collectibles.

Current Liabilities

In similar fashion, current liabilities include all the debts and expenses the firm expects to pay within a year or one business cycle, whichever is less. This typically includes all the normal costs of running the business such as rent, utilities, materials and supplies; interest or principal payments on debt; accounts payable; 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 coming due.

Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and generally, the higher the ratio, the better.

$\begin{aligned} &Current Ratio= \frac{Current Assets}{Current Liabilities} \end{aligned}$​CurrentRatio=CurrentLiabilitiesCurrentAssets​​

For the fiscal year ending December 31, 2017, The Coca-Cola Company (KO) had current assets valued at $36.54 billion. They included cash and cash equivalents, short-term investments, marketable securities, accounts receivable, inventories, prepaid expenses, and assets held for sale.

Coca-Cola had current liabilities for the fiscal year ending December 2017 equaling $27.19 billion. The current liabilities included accounts payable, accrued expenses, loans and notes payable, current maturities of long-term debt, accrued income taxes, and liabilities held for sale.

According to the information above, the company's current ratio is 1.34:

$36.54 billion ÷ $27.19 billion = 1.34

While working capital funds do not expire, the working capital figure does change over time. That's because a company's current liabilities and current assets are based on a rolling 12-month period.

The exact working capital figure can change every day, depending on the nature of a company's debt. What was once a long-term liability, such as a 10-year loan, becomes a current liability in the ninth year when the repayment deadline is less than a year away. Similarly, what was once a long-term asset, such as real estate or equipment, suddenly becomes a current asset when a buyer is lined up.

Working capital as current assets cannot be depreciated the way long-term, fixed assets are. Certain working capital, such as inventory and accounts receivable, may lose value or even be written off sometimes, but how that is recorded does not follow depreciation rules. Working capital as current assets can only be expensed immediately as one-time costs to match the revenue they help generate in the period.

While it can't lose its value to depreciation over time, working capital may be devalued when some assets have to be marked to market. That happens when an asset's price is below its original cost, and others are not salvageable. Two common examples involve inventory and accounts receivable.

Inventory obsolescence can be a real issue in operations. When that happens, the market for the inventory has priced it lower than the inventory's initial purchase value as recorded in the accounting books. To reflect current market conditions and use the lower of cost and market method, a company marks the inventory down, resulting in a loss of value in working capital.

Some accounts receivable may become uncollectible at some point and have to be totally written off, which is another loss of value in working capital. As such losses in current assets reduce working capital below its desired level, it may take longer-term funds or assets to replenish the current-asset shortfall, a costly way to finance additional working capital.

A healthy business will have ample capacity to pay off its current liabilities with current assets. A higher ratio of above 1 means a company's assets can be converted into cash at a faster rate. The higher the ratio, the more likely a company can pay off its short-term liabilities and debt. 

A higher ratio also means the company can easily fund its day-to-day operations. The more working capital a company has means that it may not have to take on debt to fund the growth of its business. 

A company with a ratio of less than 1 is considered risky by investors and creditors since it demonstrates that the company may not be able to cover its debt if needed. A current ratio of less than 1 is known as negative working capital. 

We can see in the chart below that Coca-Cola's working capital, as shown by the current ratio, has improved steadily over the last few years.

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 quick ratio excludes inventory, which can be more difficult to turn into cash on a short-term basis.

The value of working capital should be assessed periodically over time to ensure no devaluation occurs, as continuous operations require enough working capital in place.