Key Takeaways
- Working capital is the difference between the current assets of the firm and its current liabilities.
- The formula to calculate working capital is 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 the Meaning of Working Capital?
Working capital, sometimes also referred to as net working capital, is the difference between the 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. In the corporate finance language, the term “current” means a period of one year or less.
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.
What is the Importance of Working Capital?
Working capital is very important for any business to keep the organization financially stable. A company can indeed be profitable and 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.
What Does Positive and Negative Working Capital Indicate?
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 be a bad indication for a company, but a prolonged negative working capital might be.
Major Types of Working Capital
Working capital is an essential fund used for daily business operations, classified into various types based on need and application. Let’s explore the different types of working capital:
- Permanent Working Capital: These are a consistent amount of funds available even in the slow periods for the business to keep operating.
- Temporary Working Capital: These funds are required over the permanent capital to run the business efficiently during seasonal fluctuations and for special projects.
- Gross Working Capital: Current assets, cash, inventory, and accounts receivable are the funds that count as gross working capital.
- Net Working Capital: These funds convey the actual liquidity available after considering current assets and current liabilities.
Elements of Working Capital
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. Accounts Receivable
Accounts receivable are 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. Accounts Payable
Accounts 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 ongoing 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.
Understanding the Working Capital Cycle or Cash Conversion Cycle
The working capital cycle explains how cash flows in and out of the business to help maintain operational efficiency all the time, including slow trading periods and peak seasonal fluctuations. Read the following points to know what the working capital cycle unveils:
- Tracking the working capital cycle uncovers how cash moves during daily business operations.
- It includes how money is used for buying inventory and raw materials for the business.
- Records the selling of inventory for cash or credit.
- If the product is sold on credit, then the business awaits payment from the customer.
- Once all the cash flows in, the cycle is complete with cash available again for the daily business operations.
Different Outcomes of the Working Capital Cycle
- A short cycle period conveys a quick recovery of funds and better liquidity for the business.
- The longer it takes to recover the cash, the business will not be able to invest in inventory or raw materials, which affects the daily operations negatively.
- Working capital cycle helps understand the right time when cash flows in, allowing businesses to reduce dependency on external funds and use them efficiently.
What Strategies Can a Company Use to Enhance Its Working Capital?
The 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 a 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 an 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.
