Working capital refers to the amount which the company requires with the purpose of financing the day to day operation and example of which includes the working capital of $100,000 with a manufacturer which is calculated by subtracting current liabilities of $200,000 from the current assets of $300,000.
Top Examples of Working Capital
Working Capital refers to the Funds available with the Company to meet its day to day Business operations. It is an indicator of the Short Term Financial Strength of the Company and signifies the capability to meet the Current Liabilities and Debt Obligations due within one year. The following working capital example provides an outline of the most common sources of working capital.
- Spontaneous: It refers to the Funds which are easily available in market
- Sundry Creditors
- Bills Payable
- Trade credit
- Notes Payable
- Short Term WC :
- Bills Discounting
- Cash Credit
- Bank OD
- Commercial Paper
- Inter Corporate Loans and Advances
Each example of the Working Capital below states the topic, the relevant reasons, and additional comments as needed
Calculation Examples of Working Capital
Example #1
Suppose ABC Limited has Current Assets $ 5,00,000 and Current Liabilities of $ 300,000. Fixed Assets are $ 1,00,000. Long Term Debt is $1,00,000 and Short Term Debt included in the Current Liability above is $25,000. Calculate the Working Capital of the Company and analyze the same.
Solution:
Here, Gross Working Capital = Current Assets of the Company = $5,00,000
Permanent Working Capital = Fixed Assets of the Company = $1,00,000
Calculation of Net Working Capital is as follows –
- NWC = Current Assets – Current Liabilities
- = $5,00,000 – $3,00,000
- = $2,00,000
Temporary WC will be –
- Temporary WC = NWC – PWC
- = $2,00,000 – $1,00,000
- = $1,00,000
Analysis:
In the above example of working capital, ABC Limited has a Strong Working Capital to meet its Short Term as well as Long Term Financial needs. However, the Current Ratio of the Company is slightly below the Industry average of 2 which the Company needs to improve in the future. Further Temporary WC of ABC Ltd is also positive which is a good sign.
Example #2
Suppose ABC Limited has Current Assets of $10,00,000 and Current Liabilities of $15,00,000. Calculate the WC of the Company.
Solution:
In this case, The Gross Working Capital will be $10,00,000, however, the NWC of the Company would be (-$5,00,000 ) since the Current Liabilities are more than the Current Assets of the Company. ABC Limited is suffering from Liquidity Crisis due to the negative Working Capital of the Company which will hinder the Business Operations in the long term.
Such a high negative WC is a negative sign as far as the Credit Rating Agencies are concerned which would force them to downgrade the Rating by one notch if the situation does not improve in the Future.
Example #3
XYZ Limited has Current Assets of $2,00,000 and Current Liabilities of $ $90,000. Accounts receivable of$ 75,000 included in current Assets are declared as Bad Debts and shall be written off to the Profit & Loss Account next year.
Solution:
In this case, although the Net Working Capital is positive ie. $110,000 on paper, in reality, this would not be the true picture since $75,000 is considered as Bad & Doubtful of Recovery. In true sense, the Net Working Capital will have to be adjusted with the Accounts Receivable portion to work out the Revised Net Working Capital of XYZ Limited as this will impact the Strategic Decision making of the top management.
Example #4
PQR Limited has Current Assets of $2,00,000 and Current Liabilities of $ $90,000. Inventory of$ 1,50,000 included in current Assets have become Obsolete since the Goods are lying in Inventory for more than 6 months. The Market Value of the same would be $50,000.
Solution:
In this case the Net Working Capital of PQR Limited as per the Balance Sheet view would be $110,000 which is a positive for the Company, however since the Market Value of Inventories as provided in the Example above has been declined to $ 50,000, this should be considered the Actual Recovery price of Inventory.
Hence the Revised Net Working Capital would be ($2,00,000 – $1,50,000 + $50,000 ) – $90,000 = $1,00,000. The management of the Company would have to sell the Inventory as early as possible in order to maintain the Liquidity.
Conclusion
Hence, it forms a major component for analyzing the Financial position of the Company and compare it with peers. A Strong Working Capital Cycle gives the Company the Cushion to perform the Business operations of the Company smoothly. A negative working capital puts the Company in tremendous Stress since the Company is not in the position to pay off its Day to Day obligations due to Liquidity issues.
- Further, it is also not advisable to lock a huge amount of Funds in the working Capital Cycle since there is a Cost attached to it. For example, a high Inventory will be a negative sign for the Company since there is a chance of the Inventory becoming obsolete. So on paper, the WC of the Company may look Good in the Short Term however it may have a significant impact if the Inventory is not Sold and becomes obsolete.
- Hence the Company should strategically plan the Cash Flow and the minimum Working Capital required to run the Business operations smoothly so that there is no high amount locked in the Current Assets or any liability is understated as this may increase/decrease the WC.
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