Working capital is the difference between a company’s current assets and its current liabilities. Assets include cash and other assets that can be converted into cash within a year, and liabilities include payroll, accounts payable, and accrued expenses. A business that maintains positive working capital has the ability to cover its short-term financial obligations as well as invest in future growth.
There are different types of working capital, however, including trade working capital. You calculate trade working capital in the same way as working capital, except you only consider assets and liabilities directly associated with your daily business operations.
Read on for a closer look at trade working capital, including how it differs from working capital, how it’s calculated, and why it’s an important performance metric for business owners to know.
Key Points
• Trade working capital is the difference between a company’s assets and liabilities that are linked specifically to day-to-day operations.
• Current assets include inventory and accounts receivable; current liabilities include accounts payable.
• Positive trade working capital allows you to see how much cash your business has on hand for short-term commitments and investments.
• Negative trade working capital means your business may have to take on additional debt to meet financial obligations or is at risk of going bankrupt.
What Is Trade Working Capital?
To understand trade working capital, it’s important to know what working capital is. Simply defined, working capital (also known as net working capital) is a financial metric calculated as the difference between current assets and current liabilities. The formula for working capital is:
Current Assets – Current Liabilities = Working Capital
A current asset is any asset that can be converted into cash within a year, while a current liability is any amount owed to a creditor within a year. These items are listed on a business’s balance sheet.
So, what is the difference between working capital and trade working capital?
Like working capital, trade working capital is defined as the difference between a company’s current liabilities and current assets. Unlike working capital, trade working capital only considers liabilities and assets that are directly linked to day-to-day business operations.
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How Trade Working Capital Works
Trade working capital specifically looks at the difference between current assets and current liabilities directly associated with a company’s core operations.
As a result, the only current assets you include when using the trade working capital formula are:
• Inventories: These are unsold products waiting to be sold.
• Accounts receivable: This is the balance of money due to your company for goods or services delivered or used but not yet paid for by customers.
For current liabilities, the trade working capital formula only includes:
• Accounts payable: This is the amount your company owes its vendors for inventory-related goods, such as business supplies or materials.
To calculate trade working capital, you simply add inventories and accounts receivable together and then subtract accounts payable.
Business owners, as well as investors and lenders who offer small business loans, might use this more refined version of working capital because the items listed above are the major drivers of a company’s working capital. As a result, calculating trade working capital vs. working capital might better reflect the company’s financial position.
| Trade Working Capital | Working Capital | |
|---|---|---|
| Incorporates all current assets | X | ✓ |
| Incorporates all current liabilities | X | ✓ |
| Only includes assets directly related to day-to-day operating activities | ✓ | X |
| Only includes liabilities directly related to day-to-day operating expenses | ✓ | X |
The key difference between trade working capital vs. working capital is what’s included in the “current assets” and “current liabilities” parts of the working capital equation.
Trade working capital only looks at assets and liabilities related to a company’s daily operations. Working capital, on the other hand, takes into account all current assets (including cash, marketable securities, accounts receivable, prepaid expenses, and inventories) and all current liabilities (including accounts payable, taxes payable, interest payable, and accrued expenses).
Like working capital, trade working capital represents the amount of excess capital a company possesses. But since trade working capital is a narrower definition of working capital, it’s seen as a more stringent measure of a company’s short-term liquidity.
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How to Calculate Trade Working Capital
Here is an example of how to calculate trade working capital using a fictional company called XYZ that manufactures boxes.
Company XYZ has $20,000 in account receivables associated with daily operations and $5,000 in unsold inventory. It also has $7,000 in account payables associated with daily operations. Therefore, it’s trade working capital is:
$20,000 + $5,000 – $7,000 = $18,000
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What Trade Working Capital Indicates and Why It Matters
Like working capital, trade working capital is important to know because it tells you if your company has enough cash on hand to manage its short-term commitments. Positive trade working capital also indicates that your business has the ability to invest in new equipment and assets that can increase revenues and profits.
If, on the other hand, your company’s current liabilities exceed its current assets (in other words, you have negative trade working capital), your company may need to take on additional debt in order to avoid defaulting on its bills or, worst case scenario, could be at risk of going bankrupt.
It’s important to keep in mind, however, that there is such a thing as too much trade working capital. This can be a sign that your company is not investing its extra cash strategically and may be missing out on opportunities for expansion and growth.
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The Takeaway
Working capital is a financial metric calculated as the difference between current assets and current liabilities. If your business has positive working capital, it means the company can pay its bills and also invest to spur business growth.
There are several types of working capital, including trade working capital. With trade working capital, you only consider current assets and current liabilities that are associated with daily business operations.
Businesses will often calculate both forms of working capital to assess their financial health at a given moment in time. If you’re in the market for any type of small business loan, lenders may look at your working capital and/or trade working capital to assess your firm’s ability to cover new debt on top of its current financial obligations.
If you’re seeking financing for your business, SoFi is here to support you. On SoFi’s marketplace, you can shop and compare financing options for your business in minutes.
FAQ
How is trade working capital calculated?
Trade working capital is typically calculated by adding inventories and accounts receivable together, then subtracting accounts payable.
How are trade working capital and net working capital different?
While the equation is the same (current assets – current liabilities = working capital), there is a slight difference between trade working capital and net working capital. Trade working capital only looks at assets and liabilities related to a company’s daily operations, whereas net working capital takes all current assets and all current liabilities into account.
Is high trade working capital a good thing? When isn’t it?
It’s a good thing to have positive trade working capital because it means your company has access to enough funds to meet its day-to-day operating expenses, plus invest in the future. High trade working capital, however, isn’t necessarily a good thing. This can indicate that your company is favoring liquidity over investing in new assets and growing the business.
Photo credit: iStock/maroke
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