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Published : October 3, 2023, Updated : October 17, 2023

Understanding Working Capital: Formula, Elements, and Constraints

Understanding Working Capital: Formula, Elements, and Constraints

Are you a budding entrepreneur who has just started, or are you an established company that has been in existence for years now? Whatever the answer is, there’s one common thing between them, which is working capital. A proper knowledge of working capital is paramount to managing your business well financially. People aware of this will agree!

Therefore, in the blog, we will try to get into the basics of working capital, including its elements, limitations, and a lot more. Let’s get straight into it!

Key Takeaways

Working capital is the difference between current assets of the firm and its current liabilities.
The formula to calculate working capital is Working Capital = Current Assets – Current Liabilities.
Positive working capital means the assets of the company are greater than the liabilities, and negative working capital means the reverse.
Companies can increase their working capital by increasing current assets, reducing short-term debts, and optimizing financial practices.

What Is Working Capital?

Working capital, sometimes also referred to as net working capital, is the difference between current assets of the firm and its current liabilities. It’s a common way to check how well a company is doing in the short term.

Current Assets: Cash, Accounts Receivable/Customers’ Unpaid Bills, and Inventories of Raw Materials and Finished Goods. These are things a company owns that they plan to use or sell within one year as part of their regular business.
Current Liabilities: Accounts Payable and Debts. These are the bills a company needs to pay within the next year, like what they owe to others for goods or services.

Pay Attention: In the corporate finance language, the term “current” means a period of one year or less.

What is the Importance of Working Capital?

Working capital is very important for any business to keep the organization financially stable. It’s true that a company can be profitable and can still go bankrupt. In simple terms, a business can’t use imaginary profits to pay real bills; it needs actual cash to do that. In that regard, working capital holds immense value in any company’s account books.

What is the Formula To Calculate Working Capital?

The simple formula to calculate working capital is to subtract a company’s current liabilities from its current assets. Both of these statements are available in the financial statements of public companies, which are also publicly available. For private companies, the information can be confidential.

Working Capital = Current Assets – Current Liabilities

Example: Suppose a company has current assets of $100,000 and $30,000 of current liabilities. The working capital of the company in that case will be $70,000. This means the company has $70,000 available right now if it needs to get money quickly for a specific purpose.

Positive Working Capital: When the working capital figure of a company is positive, it means the company’s assets are greater and it has enough resources to meet its short-term debt.

Negative Working Capital: When the working capital figure of a company is negative, it means the company’s assets are less than its liabilities. The company’s short-term debt is greater than the resources it has. A negative working capital position could mean some potential problems for a company.

Please Note* A short-term negative working capital might not also be a bad indication for a company, but a prolonged negative working capital might be.

Working Capital Elements

A company’s balance sheet has all its assets and liabilities mentioned, but a service company might have a different approach.

Current Assets

Current assets are the receivables of a company that it expects to get in the next 12 months. The company has a claim or right to receive the financial gain, and calculating working capital assumes that the corporation liquidates all of the items listed below into cash.

1. Inventory

All the unsold goods that are stored in the inventory fall under this category. It could be raw materials, finished goods, partially assembled goods, or everything.

2. Cash & Cash Equivalent

All the money that the company has on hand falls under this category, like foreign currency and investments with low risk and low tenure.

3. Notes Receivable

These are promises from other people or businesses to give money, usually through a written agreement that’s been signed.

4. Account Receivable

Account receivable is the money that customers have to pay the company for buying things on credit. Though it’s the total amount, the money that is not expected to be paid is already deducted from the calculation.

5. Prepaid Expenses

Prepaid expenses are the money recorded as something that’s spent on things that the company will use later. It’s valuable in the short term.

Current Liabilities

Current liabilities are the debts that a company has or will have in the coming 12 months. Working capital’s main goal is to figure out if a company can pay off all its short-term debts using the money and things it currently has.

1. Account Payable

Account payable are all the bills and dues that a company has to pay, including supplies, rent, taxes, etc.

2. Wages Payable

This includes all the salaries payable to the staff.

3. Dividend Payable

These are the payments that a company is obliged to pay to all its stakeholders.

4. Accrued Tax Payable

Accrued tax payable is the money that a company has to pay to the government, usually within the next year.

5. Current Portion of Long-Term Debt

These are payments a company has to make soon for loans or debts they’ll be paying off over a longer time.

Limitations Of Working Capital

With all the other necessary information, it’s equally important that you are well aware of its limitations to make a wiser and more informed decision.

Working capital is an on-going operation and changes keep coming regularly.
Working capital usually fails to distinguish between types of accounts, which might put the statement at risk of an error.
Asset devaluation and external factors can swiftly alter working capital.
It’s possible that the working capital will change due to certain reasons that might be beyond the control of the company, like economic shifts or anything else.
The focus of the working capital statement is always on the short-term gain and not the long-term profitability.

What Strategies Can a Company Use to Enhance Its Working Capital?

Following are some of the key points on how a company can enhance its working capital.

By Increasing Current Assets

Save cash for better use.
Have a high inventory reserve.
Consider paying well in advance if that can get you some discount.
Carefully choose your customers to bring down the risk of bad debt.

By Reducing Short-Term Debts:

Avoid costly debt at all costs.
Secure favorable credit terms.
Monitor your spending closely, both externally and internally.

By Optimizing Financial Practices:

streamline financial operations for efficiency.
Always have an effective cash management strategy.
Try to get a balance between asset growth and liability control.

In case of emergency, the company can reach out to Credlix. Our solutions are designed to address the challenges exporters encounter when seeking financing. We do this by employing an innovative, technology-driven financing approach that helps them overcome working capital limitations.

Final Words

The crux is that working capital is essential to the day-to-day operations of any business. It’s important to manage short-term finances and pay bills on time. Understanding its formula, elements, and limitations is important for anyone concerned. In times of need, solutions like those offered by Credlix can provide a helping hand to overcome working capital challenges.

Also Read: 7 Tips for Suppliers on Working Capital Planning in 2021

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