Working capital, as the name suggests, is the capital that keeps a business running. Something that’s “working”. Hence the name.

Capital of a business is nothing but the difference between assets and liabilities.

Assets are anything a business owns that’s expected to give future benefits. Example: machinery, building, furniture, inventory, trade receivables, cash, etc.

Liabilities, on the other hand, are anything a business owes that will require future payments or service. Example: trade payables, bank loans, advances from customers, pending salaries, etc.

So, capital is the difference between assets and liabilities on a date. In other words, capital is the excess of assets over liabilities. Example: If a business on a particular date owns assets worth $100,000 and owes liabilities worth $80,000, that means the capital of the business on that date is $20,000 ($100,000 – $80,000).

• Assets mean, “I’ll earn money from them.”
• Liabilities mean, “I need to pay them.”
• Capital means, “The excess money I’ll be left with if I sell all my assets and pay all my liabilities.”

So, when someone says, “My business has strong capital,” what they really mean is its asset value is high, and it has few liabilities (comparatively) to repay.

Now, what’s the “working” part of the capital?

Look, all assets and liabilities aren’t the same. Some assets like furniture, machinery or buildings can’t give immediate benefit to the business. They’re long term in nature. Similarly, some liabilities, like long-term loans, aren’t payable in the near term. These are called non-current assets and liabilities. Since they don’t help in generating income or require payment in the near term, they aren’t active or “working”.

Assets and liabilities other than non-current assets and liabilities are called current assets and current liabilities. These are the assets and liabilities that are expected to give benefits and are payable in the near term. Example: Inventory, trade receivables and cash are current assets. Example: Pending salaries, short-term loans, and trade payables are current liabilities.

Technically, the near term I’m talking about here is 12 months. So, an asset that’s expected to repay benefits within 12 months is called a current asset. Whereas, a liability that’s expected to be repaid within 12 months is called a current liability.

Current assets and current liabilities are always active or in a “working” mode. In a normal business cycle (yes, in the near term), you use cash to buy inventory, inventory gets sold on credit and creates trade receivables, and then customers pay, which makes trade receivables become cash again. Similarly, trade payables get paid regularly in the same cycle.

So, the difference between current assets and current liabilities is called working capital. It’s the capital that’s working hard to keep your business running.

If current assets are more than current liabilities, that means there won’t be much trouble in running the business smoothly. You can pay suppliers on time, buy new inventory, and pay employees on time, etc.

Makes sense?

Let’s understand the concept of working capital better with an example.

Imagine you’re starting a business with your personal savings of $80,000. But that’s not enough. So, you approach a bank for a loan of $30,000. Also, one of your friends lends you $10,000. The bank loan is not repayable within 12 months. But your friend expects repayment within 12 months. So, in total, your startup fund is $120,000, right? Now, you decide to use that money to buy some inventory worth $50,000, furnish your warehouse for $20,000, and buy a delivery vehicle for $20,000. You decide to keep the rest $30,000 in the bank.

So, at the point of starting your business, your current assets are $80,000 ($50,000 + $30,000). And your current liability is $10,000. So, the working capital at the start is a healthy $70,000 ($80,000 – $10,000).

Now, your business does well in the next 1 year. You make sales, hire employees, buy more inventories, etc.

After a year, your assets include:

• Cash: $15,000
• Inventory: $60,000
• Trade receivables (customers who bought on credit and are yet to repay): $40,000
• Furniture: $18,000 (after depreciation)
• Delivery vehicle: $16,000 (after depreciation)

Your liabilities include:

• Long-term loan from bank: $30,000
• Salaries payable: $10,000
• Trade payable (suppliers that need to be repaid): $15,000

The current assets after a year are $115,000 (cash, inventory and trade receivables) and the current liabilities after a year are $25,000 (salaries and trade payables). So, the working capital is the difference between current assets and current liabilities. That’s $90,000 ($115,000 – $25,000).

High current assets and lower current liabilities = Healthy working capital

As you can see, your working capital increased from $70,000 to $90,000 in a year.

This shows, for example, that your profitability in the first year was strong, and that you repaid your suppliers on time. More profit means more cash and trade receivables. Which means more current assets. Repaying suppliers on time means fewer trade payables, which also means lower current liabilities.

But a high working capital or an increase in working capital is not always a good sign.

In our example, what if you took a new long-term (payable after 12 months) within the first year to buy a lot of inventory that didn’t sell? Yes, the inventory will be up significantly, which will increase current assets (without affecting current liabilities). So, the working capital might look healthy from the outside, but buying inventory that’s stuck that too from a long-term loan isn’t a good sign. In the long run, long-term borrowings need to be repaid. Where will the money come from?

Similarly, if trade receivables are going up since your customers are delaying payment, this will also increase current assets and hence working capital. But customers not paying on time isn’t what a business wants. In the long run, stuck trade receivables will affect your cash flow. There’s a saying “Profit is on paper. Cash flow is real.”

It may also happen that you’re paying suppliers too fast. What that does it reduce trade payables, which reduces current liabilities. There’s nothing wrong with paying suppliers too fast. It’s just that you’re draining your cash faster than necessary, and losing the benefit of supplier credit.

So, whenever you see working capital that’s “healthy”, you study the numbers carefully and look for a pattern. Preferably, compare the current numbers with the past ones. What has changed? Is the increase in working capital just because of profitability and strong sales or is there something that doesn’t meet the eye?

Have questions? Comment below.