Working capital is the money a company uses to finance its daily operations. Accountants usually measure it by adding up a company’s cash, accounts receivable, and inventory, and then subtracting short-term debts.
Working capital is a category of resources that includes cash, receivables, and inventory, minus whatever a company owes under short term liabilities. It comes straight from the balance sheet, and it’s often calculated according to the following formula:
Total Working capital = accounts receivable + inventory – accounts payable
(Excerpts from Financial Intelligence, Chapter 28 – The Magic of Managing the Balance Sheet)
Companies generally look at three main components when measuring working capital: accounts receivable, inventory, and accounts payable. A change in any of these elements either increases or decreases working capital, as follows:
- Accounts receivable is the use of cash to finance customers’ purchases, so an increase in A/R increases working capital
- Inventory is the use of cash to purchase and stock inventory for sale to customers, so an increase in inventory also increases working capital
- Accounts payable is money owed to others, so an increase in A/P decreases working capital