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.
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.
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
The following steps should be applied for working capital calculation of the business:
Let us go through some examples to understand the for working capital calculation.
Tithing Inc. has the following information for you –
Current Assets –
Current Liabilities –
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.
Using the formula, we get –
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
Working capital management depicts so many things about a company.
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.
By properly analyzing the expenses payable or to be incurred shortly, the financial team of an enterprise would easily plan for their funds accordingly.
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.
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.
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.
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.
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.
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.
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.
Thus the above problems are also vital while assessing the financial condition of the company.
Both the above concepts are important for evaluating the financial stability of the entity, but there are differences between the two approaches.
However, both of them show a positive picture if the level is higher.
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.
2. What are the determinants of working capital?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.
3. How do working capital loans work?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 –
