Cash Flow vs Working Capital
In the previous example we examined a basic cash flow statement. We saw how to properly track inflows and outflows of cash to spot potential problems. This analysis is helpful, but does not give a complete picture of working capital. Cash on hand is only a portion of working capital. To gain a complete picture of what working capital is, we will introduce the concepts of current assets and current liabilities. Working capital is the result of subtracting current liabilities from current assets. It is the best measure of a company's liquidity.
Current Assets
If we continue the example of NewStar Energy, we know that the company can use cash to finance their operations, but they can also use other current assets, or assets that will be converted into cash in less than a year. Assets such as accounts receivables and inventory can be converted in to cash in a short amount of time and should often be considered when analyzing liquidity.
Current Liabilities
When current assets are introduced into the picture we must also introduce current liabilities. These are financial obligations debts such as accounts payable and short term loans.
Once you have found current assets and current liabilities, the following equation yields your working capital:
Current Assets - Current Liabilities = Working Capital
This is the total amount of capital available to finance ongoing operations.
The Balance Sheet
As discussed previously, to quantify working capital we must find current liabilities and current assets. To find these numbers we have constructed the balance sheet attached at the bottom of this page. In practice, you should be using accounting software to generate a balance sheet.
The important thing to remember about the balance sheet is that it is simply a snapshot of a company's financial health. It shows the total assets and how those assets were financed with either liabilities or equity. This can be expressed as the equation:
Assets = Liabilities + Equity
This equation shows that an organization's assets or either funded with capital from the owner(s) or borrowed capital. In this case the equity is comprised mostly of stock (owner's capital).
The firm in question has $770,000 in total assets. This is made up of current assets as well as more long term assets that take a long time to liquidate. These $770,000 of assets have been financed with $481,000 of liability, and $289,000 worth of equity.
Now, to find working capital we simply take the current assets of $89,000 minus the current liabilities of $89,000. This yields $28,000 in working capital. This is the amount of capital the firm will have available to finance new operations in the near term.
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