What is Working Capital?

Working capital keeps your business moving—but do you really understand it? In this video, Steve breaks down what working capital is, why it matters, and how it directly affects your day-to-day operations.

You’ll learn how to manage cash, receivables, payables, and inventory in a way that keeps your business financially healthy and positioned for growth. If you want to avoid cash crunches and unlock smoother scaling, mastering this concept is a must.

TRANSCRIPT:

Understanding working capital in the business is really critical because it can bankrupt you if you don't. Now, oftentimes it's overly complicated, but I'm going to keep it really simple and explain the two use cases in the calculation behind each. Let's just define working capital for starters.

I'm just going to abbreviate here in its most simplistic form. On the balance sheet, we have assets equal liabilities plus equity. Now, under assets and under liabilities, we have current items.

Now, current items just represent things that are going to mature and convert into cash theoretically within a 12 month timeframe under assets or items under liabilities that are due and payable within a 12 month timeframe. So when I say the word current, just think of within 12 months. So under liabilities, we also have current items as well.

Now, under current assets, we have cash and cash equivalents. We have accounts receivable, the amount of money that customers owe the company for work that's been performed, but not paid for. We may also have inventory and then things like prepaids, et cetera.

These are the main accounts here. All right. I'm just keeping things very high level.

Now, under current liabilities, most companies have accounts payable. This represents the amount of money that a company owes its vendors for buying things on account. And then there may be some payroll liabilities.

So think about it. You pay your employees, then you withhold a portion for taxes that you have to submit to government agencies, but it's not like you do that right away. So you withhold the money and then you may submit it the following week or at the end of the month, whatever it may be.

So these amounts are liabilities that the company owes, but they haven't been paid out yet. So they're sitting under current liabilities. You may also have items like gift cards.

You may use a credit card as a revolving line of credit, and then you may have some other accrued expenses. All right. That just haven't materialized yet on the income statement.

Okay. So these are the main accounts. It may look different for your company, but these are the main things under current liabilities and under current assets.

So the most simplistic definition of working capital is this current assets minus current liabilities. All right. That's the textbook answer.

So let's just say you take all these account balances and they add up to $200. You take all these amounts right here under current liabilities and they add up to a hundred dollars. Therefore you would have current assets of 200 minus current liabilities of 100 and you have working capital of 100.

All right. Now this is just a static amount as of a certain date in time, because remember a balance sheet is as of a certain date of time. For example, you may pull a balance sheet as of 1231 and it's a snapshot of the company's financial position at that date versus an income statement or a statement of cash flows, which is pulled over a period of time.

All right. So that's important to understand. So if you're just calculating working capital at one point in time, say 1231, this is your working capital balance.

Now we want to understand oftentimes the change in working capital. So to do that, you would just look at the next period, whatever you want to compare. I'll just go to the next quarter and let's say current assets went from 300 and current liabilities went to 150.

Well, the difference between this is 150 and therefore we had a change 100 to 150. So the change was actually negative 50 in working capital. I just took the difference in 100 versus 150 and that's my change in net working capital.

All right. This is where it gets really confusing and really complex, but I'm going to keep it very simple for you. All right.

So let me keep going here. I'm just going to erase equity here on the balance sheet and just keep it to this. When you have a current asset, all right, and if a current asset increases, it means that you're going to have less cash.

Okay. Cash is going to go down. So they explain, let's say you have accounts receivable with a customer and they owe the company $100 this month and then they don't pay this bill and you bill them for additional work.

And now the balance went up to $200 the next period. Well, now you are waiting to collect on this $200. Your customer is sitting on this money because they haven't paid the bill yet.

And therefore you have less cash, right? You have $100 of less cash because on the income statement, you're recording this as revenue because you go out there and you earn the revenue. So it's showing up on your profit and loss under net income, but you haven't collected on this cash. So therefore, since you billed them and you haven't been paid for this work, you have $100 of less money, right? Of less cash.

Okay. Compared to what's showing up on your income statement. All right.

So the simple rule is when current assets go up, you have less cash. Also with inventory, think about it like this. You go out there and buy more inventory and you're sitting on more inventory.

Well, guess what? You had to use more cash to buy that inventory. And therefore, as inventory increases, since it's a current asset, you're going to have less cash. Now, the same thing is true.

If current assets go down, you're going to have more cash, right? Because you're collecting on that money or you're converting your inventory into sales. Now let's look at current liabilities. When current liabilities go up, guess what? You have more cash.

All right. Because think about it with vendors, accounts payable. You owe your vendors $100 for materials you put on account.

Then the next month, your balance grows to 300. Well, guess what? You have more outstanding invoices on account that you haven't paid yet. And therefore, you have more cash, right? Because you're holding onto the cash and that's why your balance is climbing.

So for current liabilities, if they go up, you're going to have more cash because you're sitting on the cash and you're not paying down the liability, right? So that's really important to understand. If you just understand this concept right here, you're going to be in good shape. So the same thing is true.

Current liabilities go down. It means you're paying down your liabilities. Well, guess what? You're paying them down.

So therefore, you have less cash. This is the relationship to understand when it comes to working capital. Now, here's where it gets a little tricky and it all comes down to use case in what you're trying to solve for with working capital.

Let me explain. And this is what tripped me up big time early on. And it wasn't until I separated the use case for working capital that I was like, ah, there is a difference because it's so nuanced.

I'd read one textbook and I'd say, yeah, exclude this or include that. And it made me super confused. So let me just keep it really simple for you.

Here's use case number one with working capital. And that is to compute your return on invested capital, right? So if you're trying to figure out your return on invested capital, then you're going to take your net operating profit after tax, okay? Your profit after you pay taxes from operations, in other words, and you're going to divide that by your invested capital. So here's the deal.

Invested capital in this use case includes both your working capital and your net property plant and equipment. Or in other words, your gross investment in things like buildings, equipment, vehicles, et cetera, to run the business, less your accumulated depreciation, right? So that's your net PP&E. But let's just focus on working capital up here.

So like I said, invested capital includes both of these items. Working capital in this situation is current assets minus current liabilities. You're like, yeah, that's what you just said, Steve.

All right. But here's the caveat. When computing invested capital, we want to figure out how much capital is tied up in the business for normal operations.

In other words, how much capital is required to support operations of the business to spin off this net operating profit after tax? So in this scenario with current assets, we are going to exclude excess cash. Whoa, what do I mean by that? In a business, a company has a bunch of cash, right? Let's say a company is sitting on $2 million in cash. But when we look at their overhead, let's just look at their OpEx, and let's say their OpEx is on average $500,000 per month.

And therefore, we may say we want enough cash in the company to cover three months of OpEx. Well, that would mean we should be sitting on $1.5 million in cash just to cover normal operations. Anything in excess of this is going to be excess cash.

So if the business is sitting on $2 million, but it only really needs to maintain about one five in its account, then that means it has $500,000 in cash that it should be investing or distributing to investors or paying down debt or whatever it may be. But it's sitting on this excess cash, so it's skewing the cash number. So when we're looking at invested capital, we just want to look at the amount of capital required to run operations.

That's why we have to exclude excess cash. The other thing is, with current liabilities, we don't want to have any interest-bearing debt in this calculation. So we're just going to exclude interest-bearing debt.

What does that mean? If you have a credit card that you use for a company for working capital, and you pay down the balance every single month, maybe you just want the points, then that number is going to be included in the calculation. But if you're using your credit card, you're swiping it, and you're not paying it down, and you're incurring interest expense, or let's say you have the current portion of debt, which is very common, in your current liability number, you're going to want to exclude that. So anything that is interest-bearing regarding a liability, any interest-bearing debt, you're going to exclude that from current liabilities.

So there you have it. When you're trying to compute return on invested capital, and you need to figure out your working capital in this scenario, you're just going to do that. Take your current assets, less excess cash, and then take current liabilities, less interest-bearing debt, and do the math, and there you go.

There's your working capital number. Add that to net PP&E, and you arrive here at invested capital. Now, there's another use case here that I'm going to explain, and that is computing working capital for free cash flow purposes.

Free cash flow, abbreviated. Now, when you're trying to figure out free cash flow, then what you're going to do is you're going to look at the change in networking capital. So let's say we have our EBITDA for a company, and we want to figure out cash flow.

And let's just say our EBITDA is 1,000. So we have revenue, cost gets sold, operating expenses, all those items are up above. I'm just starting with EBITDA to keep it simple.

So to get the free cash flow, we have to subtract out depreciation and amortization to arrive at EBIT. And then let's just say this is 300. So then I arrive here at 700 in EBIT.

And then we want to account for taxes. And let's just say taxes are 300. So I end up with 400.

In net operating profit after taxes, well, this number right here is not the same thing as free cash flow. So to get to free cash flow, now that I've accounted for taxes, I need to add back non-cash items. So depreciation and amortization is a non-cash expense.

In other words, it's not a cash outflow. So we have to add back depreciation, amortization right here. And then I have to account for changes in networking capital and capital expenditures, which comes off the statement of cash flows.

Let's just say this is 100. I have to solve for changes in networking capital to arrive at free cash flow. So this is the second use case.

So remember with invested capital, I just took current assets, less excess cash, minus current liabilities, less interest debt. And I found my working capital number where you can't use that here because I'm looking for the change in networking capital. In order to figure out the change in networking capital, what I'm going to do is I'm going to look at the current assets and I'm going to exclude all cash because I'm trying to calculate free cash flow.

So if I include cash in my working capital calculation, I'm going to double count it. This is the nuance here. So here I'm going to take all my current assets except for cash, my accounts receivable, my inventory, my prepaids, et cetera.

And I'm going to come up with a number and let's say it's 100 in period one. And then I'm going to look at my current liabilities. I'm going to include all my current liabilities except for interest bearing debt right here.

So I'm going to have my AP, my payroll liabilities. I'll have my gift cards. I'll have my accrued expenses, et cetera.

And let's say this is 50. So for period one, I'm taking my current assets minus my current liabilities and I end up with 50. All right.

So now in the next period, this climbs to 200, which means I have less cash. And then my current liabilities go to 100, which means I have more cash because my current liabilities are going up. I take the difference between 200 and 100 here and I arrive at 100.

Well, now to get to my changes in networking capital, I have to take the difference between these two. So I'm going to take 50 right here minus 100 period over period. And you'll see here I have negative 50.

All right. So I have negative 50 of less cash because more money is being tied up in my working capital. So therefore I'm going to come here and I'll account for negative 50 in working capital.

And therefore I take my net operating profit after tax. I add my 300. So 400 plus 300 is 700 minus this 50 right here.

So that's 650 minus my $100 in capex. And I arrive at 550. So that's the second use case.

As you can see, there are some nuances when calculating working capital. So the next time you're in business and somebody's saying, okay, what is our working capital? You have to understand what are they trying to figure out? Are you trying to figure out a stagnant number? In other words, how much working capital is tied up in the business to figure out your return on invested capital or some other type of calculation, or are you trying to free cashflow? Because like I said, if you're including cash, any variation thereof, cash or cash, less excess cash in this calculation, and you go to plug this number into free cashflow, guess what? Your free cashflow is going to be incorrect.

All right.

I know there's been a lot of writing here up on the board, a lot of nerd talk, but I wanted to put this in video form for those of you who've been asking me to create a video like this, because I know there are a lot of questions related to calculating working capital. Also on my podcast, Boosting Your Financial IQ, I have a couple episodes where I explain working capital in more detail. So be sure to check those out if you want more context on this subject.

All right. That's all I have until next time. Take care of yourself.

Cheers