What is Working Capital & How to Calculate it?

JUMP TO SECTION

Writing a business plan?
August 22, 2022

Working capital (WC) is derived by deducting the company’s current assets from current liabilities. Although a large amount of working capital helps the firm’s smooth functioning, excess WC can indicate inefficient management.

This blog explains what is working capital, the components of working capital, and how to calculate it.

Components of Working Capital

The components of working capital include accounts receivables, cash, and bank balance, inventories, and accounts payables. Current assets and current liabilities are the two most crucial components of a company’s WC.

  1. Current Assets

    current Assets

    Current assets are more liquid than fixed assets because they can be converted into cash quickly within 12 months. Examples of current assets include cash and cash equivalents, inventory, accounts receivables, etc.

    Also, read Fixed Assets Vs. Current Assets to understand more about the current assets and how it differentiates from the fixed assets.

  2. Accounts Receivables

    Accounts Receivables

    An excellent receivables management policy ensures prompt collection and avoids bad debts. Accounts receivables account for a large portion of the current asset and, as a result, working capital. A prolonged accounts receivable period delays cash collection.

  3. Cash and Bank Balance

    Cash and Bank Balance

    Proper cash management empowers the company to manage its operational process. The business entity’s efficiency depends on its free cash flow (FCFF) generation. Better cash management allows businesses to obtain trade discounts and enhance the cash conversion cycle.

  4. Inventory

    Inventory

    The company’s success measure is its quick sales and inventory replacement. The low inventory indicates that the firm is at risk of losing revenue, and excessively high inventory levels indicate the company’s waste of operating capital.

  5. Current Liabilities

    Current Liabilities

    Current liabilities refer to the company’s short-term obligations due in less than 12 months. Accounts payable, short-term debt, current duties, and taxes are examples of current liabilities.

    Below is the most used current liabilities component to calculate the working capital.

  6. Accounts Payable

    Accounts Payable

    Companies strive to preserve optimal cash flows by balancing payments and receivables, and companies may postpone payments for as long as it is reasonable to safeguard good credit ratings. In an ideal world, a company’s average time to collect receivables is far less than its average time to manage payables.

The first and foremost requirement of working capital, therefore, is to acquire and maintain inventories.” – Dr Anil Lamba, best-selling author, and financial literacy activist.

How to Calculate Working Capital?

How to Calculate Working Capital

The amount of accessible capital that a firm may utilize for day-to-day operations is the working capital. It will tell you how liquid are your current assets and how efficiently your operations work.

Cash, marketable securities, and inventory are examples of current assets; accounts payable, accrued obligations, and short-term debt are current liabilities.

You can calculate NWC with the help of the following formula:

Net Working Capital = Current Assets – Current Liabilities

It gives you an idea of how liquid your current assets are to cover the short-term obligations due within 12 months. If it is positive, it generally means you have sufficient liquid funds to meet current liabilities.

But, if the net-working capital is negative, it shows your inefficiency to cover the short-term liabilities. Moreover, excessive working capital is difficult to dispose of, predominantly if it comprises a significant amount of obsolete inventory.

  • Calculating Current Ratio

    Working capital can also be determined by calculating the company’s current ratio. The current ratio divides the current assets with the current liabilities. The position of companies with a high current ratio is better to pay off their current liabilities than companies with a low current ratio.

    The below formula is provided to calculate the current ratio:

    Current Ratio = Current Assets / Current Liabilities
    • Example of Working Capital Calculation

      ABC Co Ltd. reported $63.45 B in current assets for the fiscal year ending December 31, 2021. Current assets comprise holdings for sale, cash and cash equivalents, prepaid costs, short-term investments, inventory, marketable securities, and accounts receivable.

      ABC Co Ltd. also reported $19.72 B in current liabilities for the fiscal year ended December 2021. Liabilities to sell, Accounts payable, accrued income taxes, accrued costs, current maturities of long-term debt, and loans and notes payable constitute the company’s current liabilities.

      The current ratio of the company will be 3.22 ($63.45 / $19.72). A higher current ratio is considered good. The current ratio of more than 1 indicates that the company has enough current assets to pay its debt.

Use the net-working capital and current ratio regularly to keep a tab on the operational efficiency of your business. It will also detect early signs of inventory devaluation.
  • Working Capital Outcomes – Positive or Negative

    WC can be positive (current assets exceed current liabilities) or neutral (current assets equal current liabilities) and negative (current liabilities exceed current assets). Positive working capital means more money coming in and less money going out.

    The company may have negative working capital due to the following reasons:

    • A firm makes significant one-time cash payments
    • Increasing accounts payable owing to necessary credit extension
    • Reduction in receivables

    The Outcome of a Positive Working Capital

    The Outcome of a Negative Working Capital

    • Several loan denials
    • Reckless expenditure
    • Failure to make payments
    • Bankruptcy

    Nevertheless, positive WC is not always advantageous for the business. Negative WC can be generalized as upcoming doom.

    Should You Be Worried about Negative Working Capital?

    Nevertheless, a company’s negative WC might be favourable depending on the type of business. Negative WC might also indicate that the company’s working cycle is short and that its return on investment on finished goods converts to cash before the supplier’s payment due dates.

    For instance, the high inventory turnover rates of fast-food franchises and supermarket stores produce revenue quickly. But heavy equipment and industrial manufacturers have difficulty raising funds rapidly, which could be the reason for deficits.

Importance of the Working Capital in Business

  • Working capital to a business is what oil is to machinery, and it is essential for the company’s daily work. A well-run business should have enough WC on hand to cover its expenses for a year.
  • By looking at a company’s working capital, you may determine if it can develop organically or seek extra funding from banks or investors.
  • One of the most significant benefits of examining a company’s working capital condition is predicting potential financial problems. If a company with billions of dollars in fixed assets can’t pay its payments when they’re due, it may soon find itself in bankruptcy court.
  • In the best of conditions, a lack of WC may put a firm under a financial strain, causing it to borrow more and make more late payments to creditors and vendors.
  • All of this might result in a worse corporate credit rating and less investor interest in the long run. As the cost of capital rises, a lower credit rating means banks and the bond market will demand higher interest rates, lowering revenue time.
  • WC ensures that a firm can pay its employees and suppliers. It may also support corporate expansion without having to take on debt. Working capital might make it simpler for a firm to qualify for loans or other credit types if it needs to borrow money.

Conclusion

The business must not confuse its short-term working capital requirements with longer-term, permanent requirements. For instance, the company cannot use it to buy machinery or land or hire permanent personnel, and these are expensive and need a variety of financing options.

If a company has to pay project-related expenditures or temporarily reduce revenues, it may enhance its working capital. Adding to current assets or lowering current liabilities are two strategies for closing the gap, and taking on long-term debt and selling liquid assets for cash are two choices.

At Upmetrics, we have the solutions to help you with efficient working capital management. With proper resource allocation and planning, we can work together to end your working capital woes.

Don't forget to share this post!
Rudri Mehta
Rudri Mehta
Rudri is a passionate financial content writer and a Chartered Accountant by profession. She enjoys sharing knowledge through her writing skills in finance, investments, banking, and taxation while also exploring graphic designing for her own content.

Reach Your Goals with Accurate Planning

No Risk – Cancel at Any Time – 15 Day Money Back Guarantee

Download Your Template Now

We care about your privacy. See our Privacy Policy

[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[Template]
[Template]
[class^="wpforms-"]
[class^="wpforms-"]
[Template]
[Template]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]
[class^="wpforms-"]