Working capital is current assets minus current liabilities. It is used in several ratios to estimate the overall liquidity of a business; that is, the ability to meet obligations when due. At a high level, the calculation of working capital is as follows:
Current assets - Current liabilities = Working capital
The calculation can be refined to a much greater extent by considering the following enhancements to the basic formula:
- Cash payable for dividends and stock buybacks. If there has been a specific commitment by the board of directors to issue dividends or buy back shares, it can make sense to exclude these liabilities from the cash balance, since the cash will not really be available to pay for current liabilities.
- Non-trade receivables. A company may have a large amount invested in loans to employees, for which there may be lengthy repayment terms. If so, these receivables cannot be considered current assets, and so should be excluded from the calculation.
- Obsolete inventory. It can be exceedingly difficult to convert certain inventory items into cash, especially when the inventory is so old that it could be considered obsolete. In these instances, it can make more sense to include in the calculation only the amount of cash that could be extracted from inventory via a rushed sale.
- Renewable debt. If a company has routinely rolled over its short-term debt when it becomes due for payment, is this really a current liability? An argument can be made that this debt should be excluded from the calculation of working capital.
Given these additional considerations, it may be necessary to significantly modify what initially appears to be a simple calculation for working capital.
For example, ABC International has $100,000 of cash, $500,000 of receivables, $1,000,000 of inventory, and $200,000 of accounts payable. In a simplistic format, this means that its working capital calculation is:
$100,000 Cash + $500,000 Receivables + $1,000,000 Inventory - $200,000 Payables
= $1,400,000 Working capital
However, the board of directors has committed to a $40,000 stock buyback for which no liability has been recorded. There are also $20,000 of management loans within the receivables figure, and $200,000 of the inventory is likely to be obsolete. Given these additional considerations, the actual working capital calculation is:
$1,400,000 Working capital prior to adjustments
- 40,000 Stock buyback
- 20,000 Management loans
- 200,000 Obsolete inventory
= $1,140,000 Adjusted working capital