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.
What is Working Capital?
Working capital, or Net Working Capital (NWC), is the business entity's ability to pay off its current liability with its current assets, such as cash, accounts receivable/unpaid invoices from customers, and raw materials and completed goods inventories.
An organization's NWC measures its liquidity, operational efficiency, and short-term financial health. If a firm has a significant positive NWC, it should invest and grow. If a company's current assets do not meet its current liabilities, it may face difficulties expanding or repaying creditors and even declare bankruptcy.
Similar firms can operate with varying WC levels and still succeed well. It is also possible to successfully run a business with negative working capital. The WC is an essential consideration during the company's evaluation in the context of its industrial and financial structure.
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.
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.
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.
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.
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.
Below is the most used current liabilities component to calculate the working capital.
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?
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:
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.
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 business has sufficient finances to pursue new prospects
- The bank is happy to provide loans to the company
- Improved Customer satisfaction
- On-time delivery
The Outcome of a Negative Working Capital
- Several loan denials
- Reckless expenditure
- Failure to make payments
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.
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.