What is Working Capital?

Simply put, working capital is the difference between an organization’s current assets and its current liabilities. Also referred to as net working capital, it is commonly used to measure an organization’s liquidity and short-term financial health.

Assets considered include cash and cash equivalents (e.g., money market accounts), accounts receivable, inventories of raw materials, as well as finished goods and prepaid expenses. Liabilities include accounts payable; accrued wages, taxes and dividends; unearned revenue and debt. By comparing an organization’s assets and liabilities, treasurers can get a better understanding of the organization’s level of liquidity. The formula is:

Working Capital = Current Assets – Current Liabilities

What Is Working Capital


What Is Working Capital and Why Is It Important

Determining an organization’s operational efficiency, or viability, is a product of calculating its working capital. If the working capital is positive, that means the organization has enough to cover any short-term debt. Depending on the amount left over, i.e., residual cash, it may have enough to invest in or expand the business. Now, if the figure is negative, the opposite is true. The organization doesn’t have enough to cover its current liabilities and has low liquidity. Its short-term health, in this case, is poor. 

All that said, treasurers need to keep in mind the fact that working capital is not a static figure; it’s always changing. You also have to consider what your assets actually are. For example, if all your assets are in accounts receivable, that’s not a sure thing. What if your client doesn’t pay? What if they file for bankruptcy? By the same token, what if any number of things happen to your inventory, e.g., theft or fire? 

Debts aren’t a sure thing either. Agreements can be missed in the middle of a merger. Invoices can be overlooked in a fast-paced environment. 

What it boils down to is this: Accurate accounting practices are essential to formulating working capital. 

Working Capital Metrics



Working Capital Metrics

If you are working in treasury, there are fundamental metrics you need to be familiar with. These metrics are used to assess the effectiveness of working capital management, which will tell you what the firm’s default risk is — the risk that the firm won’t be able to pay its creditors. 

These metrics are also used internally to assess the company’s performance, adjust payment terms, forecast cash flows and manage liquid resources. When you understand the company’s working capital position, and its funding requirements, then you as a treasurer have the information you need to make strategic decisions that include short-term investments, borrowing, credit terms and resource allocation. 

There are a few things you will want to keep in mind when analyzing the metrics. First, there is no right or wrong number for a particular metric. Second, determining the metric’s trend is important, as is understating the factors underlying the trend. And finally, remember that metrics vary by industry and by country, so be sure to compare like to like — same industry, same country. 

The fundamental working capital metrics are:

Net Working Capital (NWC) is figured by subtracting the total current liabilities from the total current assets. It is never a ratio, but rather an absolute measure. What the NWC tells you is, if all the company’s assets were converted to cash, it would have X amount more than is needed to pay off its current liabilities. 

For example: $8,000 (current assets) - $3,400 (current liabilities) = $4,600 net working capital.

Current Ratio is figured by dividing the total current assets by the total current liabilities. What this figure tells you is the degree to which a company’s current obligations are covered by its current assets.

For example: using the same figures as above, we would have $8,000/$3,400 = 2.35. What this tells you is that the company carries $2.35 of current assets for every $1 of current liabilities. The higher the current ratio, the lower the default risk for creditors.

Quick Ratio (also known as the acid test ratio) is figured by figuring the sum of cash, short-term investments and accounts receivable and dividing that number by the total current liabilities. Just like with the current ratio, the higher the quick ratio, the lower the risk for creditors.

For example: $1,500 (cash) + $1,300 (short-term investments) + $1,700 (A/R) / $3,400 (current liabilities) = 1.32

The company has $1.32 in liquid assets for every $1 of current liabilities.

Days Cash Held is figured by dividing cash by operating expenses minus noncash expenses, divided by 365: 

Days Cash Held = Cash / ((Operating Expenses – Noncash Expenses) / 365)

What this metric tells you is the measure of the company’s liquidity, or when the company will run out of cash, assuming operating expenses are paid on time and no additional revenue comes in. Of note, noncash expenses such as depreciation are excluded from the calculation. 

For example: $1,500 (cash) / [$4,000 (operating expenses) - $200 (noncash expenses) / 365] = 144 days

However, this 144-day figure is not clear cut. The operating expenses are taken from the income statement, and are therefore treated as an average in the calculation. You would need a more detailed assessment of when operating expenses are due to achieve a more accurate figure. For example, if a major expense is due soon after the balance sheet date, the days cash held figure may be masking a potential cash shortage. By that same logic, if most major expenses are due shortly before the next balance sheet date, then days held cash would be understating the company’s cash position.   

The Cash Conversion Cycle



The Cash Conversion Cycle

The cash conversion cycle (CCC) tells you the time required to convert cash outflows associated with production into cash inflows, i.e., accounts receivable. It is figured as the average age of inventory (days inventory) plus the average age of A/R (days receivables), minus the average age of A/P (days payables). 

What is of note with the CCC is that it is critical to the monitoring of how long it takes to sell inventory, the time between when a sale is made and cash is collected, and the actual disbursement period. 

Days Inventory (DI) is figured dividing the inventory by the cost of goods sold (COGS) and multiplying that by 365. The figures for the inventory and COGS are taken from the balance sheet and income statement. 

For example: $2,600 (inventory) / $9,200 (COGS) x 365 = 103.15 days

The value tells us that it took the company an average of 103.15 days to sell its inventory. Of note: a shorter DI frees up working capital. 

Days Receivables (DR) is figured by taking the period’s ending value for A/R and dividing it by revenues, then multiplying that by 365. DR tells you the number of days of dales held in the form of A/R. 

For example: $1,700 (A/R) / $15,000 (revenues) x 365 = 41.37 days

The value tells us that the company held 41.37 days of sales in A/R during that period, or the number of days required to convert a sale into cash inflow. 

Days Payables (DP) is figured by dividing accounts payable by the COGS, and multiplying it by 365. 

For example: $1,600 (A/P) / $9,200 (COGS) x 365 = 63.48 days 

This value tells you that the company took an average of 63.48 days to repay A/P. Of note: be sure to compare the DP to the trade credit terms provided by suppliers. 

Calculating the CCC

Now that you have the DI, DR and DP, the CCC is then calculated by subtracting the DP from the sum of the DI and DR. 

For example: 103.15 (DI) + 41.37 (DR) – 63.48 (DP) = 81.04 days

What this value tells you is that, on average, 81.04 days passed from the time the company disbursed cash until it recovered cash from a sale during the prior year. 

How can you improve the CCC? 

  • Shorten the DI through careful purchasing and production schedule, and by removing excess finished goods from the inventory.

  • Shorten the DR by monitoring customer payment habits, reducing delinquencies, adjusting payment terms and using faster collection channels.

  • Increase the DP by effectively managing A/P through the acceptance of supplier discounts only when it works in your favor, i.e., don’t pay earlier than is required.


The cash turnover ratio refers to the number of cash conversion cycles a company experiences in a given fiscal period, typically a year. It is figured by dividing 365 by the CCC.

For example: 365 / 81.04(CCC) = 4.5 times

What this value tells you is that it takes 81.04 days to recover each dollar invested in the production process, and that the recovered dollar was spent again 4.5 times in the last fiscal year. With this information, you know how many times you can spend, collect and re-spend a dollar in an accounting cycle. If the number increases, then the company is using its working capital more efficiently, and of course the reverse is true if it decreases.

Managing Working Capital



Managing Working Capital and the Cash Conversion Cycle

The importance of managing cash and working capital cannot be overstated; without them, organizations simply cannot exist. Yet, when targeting growth, too many organizations focus on trying to increase sales or reduce supplier costs, while ignoring the potential benefits of efficient working capital management.

A renewed focus on internal processes can unlock working capital “trapped” in the cash conversion cycle (CCC) — the time required to convert cash outflows associated with production into cash inflows through the collection of accounts receivable. It is calculated using the following equation:

Cash Conversion Cycle = Days Inventory
Outstanding (DIO) + Days Sales Outstanding
(DSO) – Days Payable Outstanding (DPO)

For help calculating the CCC, download AFP’s Payments Guide to Unlocking the Cash Conversion Cycle

These funds are then available to be recycled back into the business. Freeing this cash has a direct impact on the business's bottom line. It allows the business to grow because working capital that was previously being used to fund an inefficient process can now be invested to help the organization achieve its strategic objectives.   

Treasury can influence the CCC in two significant ways. First, treasury can introduce, or help with the introduction of, more efficient ways of processing the data and payments associated with the physical supply chain. This is where digitization plays a major part by providing more opportunities for treasury to interrogate data across all three elements: suppliers, inventory and customers.

Second, treasury can help other parts of the organization understand the financial implications of the business decisions they make. Treasury’s influence is growing, which is due in part to a trend toward the centralization of policy setting and the emergence of technologies that allow treasury to identify and share more detailed insights with the rest of the business. By focusing on the individual elements of the CCC, treasury can help identify potential efficiencies.

Influencing the Bottom Line


Influencing the Bottom Line

Taking action to improve the efficiency of the accounts receivable cycle can result in significant improvements in DSO. Similarly, changing processes within the accounts payable cycle can help the organization improve visibility over its cash and, consequently, manage liquidity and working capital more efficiently. 

Treasury cannot directly control inventory in the same way, but the department can offer insight to the wider business to help it manage inventory more efficiently. In the same way, treasury can offer advice to help the business understand how procurement and sales decisions affect working capital and, therefore, influence the bottom line.

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