Working capital is the money used to cover all of a company’s short-term expenses, including inventory, payments on short-term debt, and day-to-day expenses—called operating expenses. Working capital is critical since it is used to keep a business operating smoothly and meet all its financial obligations within the coming year.
Why is working capital important?
Working capital is important because it is necessary in order for businesses to remain solvent. In theory, a business could become bankrupt even if it is profitable. After all, a business cannot rely on accounting profits in order to pay its bills—those bills need to be paid in cash readily in hand. To illustrate, consider the case of a company that had accumulated $1 million in cash due to its previous years’ retained earnings. If the company were to invest all $1 million at once, they could find themselves with insufficient current assets to pay for their current liabilities.
Drivers of Working Capital
Companies have both short-term assets and liabilities. A company’s short-term assets are called current assets, while short-term liabilities are called current liabilities. A company’s working capital is the difference between the value of the current assets and its current liabilities for the period.