Working capital is the difference between a company’s current assets and current liabilities.
Working capital is calculated by subtracting current liabilities from current assets. Working capital is a liquidity measure in that it indicates the amount of resources available to satisfy short-term obligations.
Financial managers and investors often distinguish between total working capital and operating working capital. Total working capital includes all current asset and current liability accounts. Operating working capital includes only current asset and current liability accounts associated with the company’s operating transactions. These accounts include accounts receivable, inventory, prepaid expenses, and accounts payable.
Operating working capital is particularly important because it is a component of operating cash flow. The operating working capital accounts indicate differences between cash flows and operating income. In other words, changes in operating working capital accounts allow us to reconcile operating income and operating cash flow.
To reconcile operating income to operating cash flow, we must recognize the following:
- An increase in an operating current asset is subtracted from income; a decrease in an operating current asset is added to income.
- An increase in an operating current liability is added to income; a decrease in an operating current liability is subtracted from income.
We can aggregate the changes in the operating working capital accounts and calculate operating cash flow by subtracting the period-over-period change in operating working capital from operating income:
Operating cash flow = Operating income – Change in operating working capital
For example, suppose a company’s operating income was $500,000 for the previous year. Operating working capital was $100,000 at the beginning of the period and $153,000 at the end of the period. Operating cash flow for the period was:
500,000 – (153,000 – 100,000) = $447,000
