Working Capital Definition
Working Capital means those liquid funds whether in form of cash, deposits in bank or in either way which is kept by an enterprise to manage the day to day running expenses of the business. It is a measure of liquidity, efficiency and financial health of a company and is calculated using a simple formula – “current assets (accounts receivables, cash, inventories of unfinished goods and raw materials) MINUS current liabilities (accounts payable, debt due in on year)”
To calculate the working capital or liquid funds of business, below mentioned formula can be used –
Working Capital Formula = Current Assets (Net of Depreciation) – Current Liabilities
The following steps should be applied to calculate the working capital of the business:
- Step #1 – Bifurcate the value of current assets and fixed assets from the list of total assets, or the same could be preferable to check the financial statements prepared as current assets of the business are specified specifically in the financials.
- Step #2 – Similarly, check the value of the current liabilities of the business.
- Step #3 – Check from the value of current assets, whether it includes any value for provision, etc. for instance, provision of depreciation or not.
- Step #4 – Deduct the value of provision find out in step 3 above from the value of current assets find out in step 1 above and called it as Current Assets (Net).
- Step #5 – Finally, by subtracting the value of current liabilities from the value of Current assets (Net), we got the value of Working Capital.
Tithing Inc. has the following information for you –
Current Assets –
- Accounts Receivables – $40,000
- Cash – $15,000
- Inventories – $34,000
- Marketable Securities – $45,000
- Prepaid Expenses – $5000
Current Liabilities –
- Accounts Payables – $35,000
- Notes Payables – $15,000
- Accrued Expenses – $12,000
- Short term debt – $34,000
Find out the WC of Tithing Inc.
From the working capital example, we will first add up the current assets and the current liabilities and then use them to calculate the working capital formula.
- The total current assets would be = ($40,000 + $15,000 + $34,000 + $45,000 + $5000) = $139,000.
- The total current liabilities would be = ($35,000 + $15,000 + $12,000 + $34,000) = $96,000.
Using the formula, we get –
- WC = Current Assets – Current Liabilities
- Or, WC = $139,000 – $96,000 = $43,000.
It means that the WC of Tithing Inc. is positive and quite healthy.
Colgate Working Capital Calculation
Below is the Snapshot of Colgate’s 2016 and 2015 balance sheet.
Let us calculate the WC for Colgate
- Current Assets (2016) = 4,338
- Current Liabilities (2016) = 3,305
- WC (2016) = 4,338 – 3,305 = $ 1,033 million
- Current Assets (2015) = 4,384
- Current Liabilities (2015) = 3,534
- WC (2015) = 4,384 – 3,534 = $850 million
Interpretation of Working Capital
WC depicts so many things about a company.
- If a company has a positive WC (meaning the current assets are more than the current liabilities of the company), then the company is in a good position in terms of efficiency, liquidity, and overall financial health.
- On the other hand, if the company has a negative working capitalNegative Working CapitalNegative Working Capital refers to a scenario when a company has more current liabilities than current assets. It implies that the available short-term assets are not enough to pay off the short-term debts. (meaning the current assets are less than the current liabilities of the company), the company is suffering from inefficiency and illiquidityIlliquidityIlliquid refers to an asset that cannot be converted to cash. Such assets suffer a valuation loss when sold in exchange for cash. Bonds, stocks and properties are some examples of illiquid investment..
It’s also important for a company to see how long the inventories sit with the company. If the inventories aren’t moving out for long, the capital will remain tied up.
Importance of Working Capital
#1 – Liquidity Management
By properly analyzing the expenses payable or to be incurred shortly, the financial team of an enterprise would easily plan for their funds accordingly.
#2 – Out of Cash
In-appropriate prepared plans of day to day expenses may result in enterprise liquidity issues. They have to postpone or to arrange funds from some other sources, which give a bad impression of an enterprise on the party.
#3 – Helps in Decision Making
By correctly analyzing the requirement of funds for day to day operations, the finance team can appropriately manage the funds and can decide accordingly for available funds and availability of funds also.
#4 – Addition in the Value of Business
As the management accordingly manages all day to day required funds that help the authorized personnel to timely pay for all the outstanding creates a value addition or goodwill enhancement in the market.
#5 – Helps in the situation of Cash Crunches
By properly managing the liquid funds, one can help the organization not to affect the situation of crises or cash crunches and pay for its day to day expenses on a timely basis.
#6 – Perfect Investments Plans
Correctly managing the funds or working capital, one can choose or plan for their investments accordingly and invest the funds to maximize the return as per their availability.
#7 – Helps in Earning Short Term Profits
Sometimes it is seen that the enterprises keep a heavy amount of funds as working capital, which is far over and above the required level of working capital. So by correctly preparing the required capital, those extra funds could be invested for a short period and could create value in the profits of the enterprise.
#8 – Strengthening the Work Culture of Entity
Timely payment of all day to day expenses mainly focused on the salary of the employees creates a good environment and a sort of motivation amongst employees to work harder and strengthening the good working environment.
Working Capital Video
This article has been a guide to Working Capital and its definition. Here we look at how to calculate working capital along with practical examples and a downloadable excel template. You can learn more about financial analysis from the following articles –