20. Ratios: Working Capital

Let's take a look at working capital. Now, working capital as a formula is pretty simple. It's current assets minus current liabilities. But what does this really mean? What does working capital actually mean? Well, let's read it backwards. It's capital that you have to work with. It's the capital that is available to work with. So if we read it backwards, why does that make sense? Well, if you've watched the other videos, we know that current assets and current liabilities both have a maturity of less than one year.

So if we know that in less than a year, we're going to have this much in assets, and in less than a year, we're going to owe this much in liabilities, we can say that in less than a year, this is the amount of capital that we have to work with. Now, a couple of considerations about working capital. If working capital is too low, then we lose our liquidity, and that means we can't pay our, that's not how you spell our, can't pay our vendors, suppliers, et cetera, et cetera. So if working capital gets too low, then we're not going to have enough money to pay all these liabilities.

Now, if working capital gets too high, that's not necessarily bad, but that may mean we're not using our money in the best way. So if working capital gets too high, that may mean we should be buying more inventory, or we should be investing in more machinery or more equipment, because we have a lot of extra working capital, and we should put that capital to work. That's what working capital is for, is to put it to work.