Working Capital Meaning
Working Capital means those liquid funds, whether in the form of cash, deposits in a bank, or either way, which an enterprise keeps to manage the day-to-day running expenses of the business. It is a measure of a company’s liquidity, efficiency, and financial health.
It 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 one year). Thus it is the fund that any entity requires to meet the financial obligations for the short term, otherwise there may be cash crunch or even bankruptcy.
Table of contents
- Working capital represents a company’s funds available for daily expenses, reflecting its financial health and efficiency. To calculate it, subtract current liabilities from current assets.
- A positive working capital occurs when a company’s assets exceed its current liabilities. This indicates efficiency, good liquidity, and overall financial health.
- Negative working capital arises when a company’s current liabilities outweigh its assets, indicating potential issues with efficiency and liquidity.
- Maintaining a healthy level of working capital is essential for a company’s stability and ability to meet short-term financial obligations.
Working Capital Explained
Working capital is the fund that the business needs to meet its daily expenses. They are funds that can be easily converted to cash and the used to meet the short-term needs.
This fund is estimated by deducting all current liabilities from the current assets that the business has. The liabilities include the short-term debts or accounts payable and current assets include the accounts receivable, cash, inventory and so on, that can be easily converted to cash.
A company with good working capital ratio can be considered financially strong because it has adequate funds to meet the current financial obligations. Therefore, there is no fear of cash crunch or hindrance in carrying on with their daily business operations.
However, on the other hand, too many liquid assets also mean the money is lying idle without generating any returns. A continuous situation like this may lead to a lack of growth, innovation, and expansion.
Working Capital Video
Let us understand the formula used to calculate the amount available as working capital for the business.
To calculate the working capital ratio or liquid funds of business, below mentioned formula can be used –
Working Capital Formula = Current Assets (Net of Depreciation) – Current Liabilities
How To Calculate?
The following steps should be applied for working capital calculation of the business:
- Step #1 – Bifurcate the value of current and fixed assets from the list of total assets. 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 business’s current liabilities.
- 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 found in step 3 above from the value of current assets found in step 1 above and call it 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.
Let us go through some examples to understand the for working capital calculation.
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.
We will first add up the current assets and the current liabilities from the working capital example 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 working capital management of Tithing Inc. is positive and quite healthy.
Below is the Snapshot of Colgate’s 2016 and 2015 balance sheets.
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
Working capital management depicts so many things about a company.
- Suppose a company has a positive WC (meaning the current assets are more than the company’s current liabilities). In that case, 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 company’s current liabilities), 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.
#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
Inappropriate prepared plans of day-to-day expenses may result in enterprise liquidity issues. They have to postpone or 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 decide accordingly for available funds and availability of funds.
#4 – Addition to the Value of Business
As the management accordingly manages all day-to-day required funds that help the authorized personnel 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 working capital cycle, 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, 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 enterprise’s profits.
#8 – Strengthening the Work Culture of the Entity
Timely payment of all day-to-day expenses mainly focused on the employees’ salary creates a good environment and a sort of motivation amongst employees to work harder and strengthens the good working environment.
Along with the various advantages , it is also necessary to look at the limitations also so that better management decisions can be made.
- Short term – The concept reflects only a short-term capability of the business to meet its financial obligations. It does not give the investors a long-term picture which is equally important to understand the financial stability.
- Does not indicate profitability – It is not a true measure of profitability because a business may have a lot of liquid fund but if the sales figures are not high or if there is no control over the costs or expenses, then the company may not be profitable.
- Depends on the industry – The working capital needs vary with industry. The manufacturing or retail industry may require high capital for short term requirements but the technology industry or companies providing financial service may not require it at such a high level.
- Fluctuations – There may be frequent changes in the needs of such funds because sudden changes in receivables or payables. Money amy also remain blocked due to technological problems. Thus, it is always possible that the fund that is expected to remain in the business may not be there when required.
Thus the above problems are also vital while assessing the financial condition of the company.
Working Capital Vs Current Ratio
Both the above concepts are important for evaluating the financial stability of the entity, but there are differences between the two approaches.
- The former is calculated as current assets minus current liabilities but the latter is calculated as current assets divided by current liabilities.
- The former shows the amount of funds available to meet short term needs and the latter shows the entity’s ability to pay the current liabilities using the current assets.
- The working capital cycle is a more comprehensive measure as compared to current ratio regarding the company’s financial stability.
However, both of them show a positive picture if the level is higher.
Frequently Asked Questions (FAQs)
The main components of working capital are current assets and current liabilities. Current assets include cash, accounts receivable, and inventory, while current liabilities encompass short-term debts, accounts payable, and other obligations that are due within one year. Working capital is the difference between current assets and current liabilities, representing the funds available to meet day-to-day expenses.
The determinants of working capital are influenced by a company’s operational and financial activities. Factors such as sales volume, production cycle, inventory management, credit terms with customers and suppliers, and the nature of the business impact working capital needs. Efficient management of these determinants is crucial for maintaining optimal levels of working capital.
Working capital loans are short-term financing options provided by financial institutions to address a company’s immediate operational needs. These loans are typically used to cover short-term expenses, such as payroll, inventory restocking, or handling accounts payable. Lenders assess a company’s creditworthiness and ability to repay the loan, and the loan terms are usually shorter in duration compared to other types of business loans.
This article is a guide to Working Capital and its meaning. We explain the formula, how to calculate, example, importance & limitations. You can learn more about financial analysis from the following articles –