Working Capital

Reviewed by Athena | Updated on Aug 27, 2020

Introduction

Working capital is used to refer to the funds required by a business in order to carry on their day-to-day operations. This is calculated by reducing the current liabilities from the current assets of the business.

The operating liquidity of a company is measured in terms of its working capital. A positive working capital is a sign of sufficient funds for efficient operability and growth, It enhances the solvency and credit-worthiness of the organisation. A negative working capital could lead to difficulties in making payments, and bankruptcy.

How to Calculate Working Capital and Working Capital Ratio?

Working capital = Current assets - Current liabilities

Working capital ratio = Current assets / Current liabilities

Current assets include the cash in hand, bank balances, accounts receivable, and inventory held. Current liabilities include accounts payable and short-term loans that are payable within 12 months.

What is a Working Capital Cycle?

A working capital cycle is the time taken to turn the current assets and liabilities of the organisation into cash. This is calculated in number of days. Companies benefit when their accounts payable cycles are longer than the accounts receivable cycles. Maintaining such a working capital cycle will help a company free up cash easily. If it is the way around, the company may need to borrow additional funds in order to pay suppliers.

Why is Working Capital Management Necessary?

A company needs to optimally manage its working capital, in order to fund short-term expenses and debt, and continue its operations efficiently. This includes effective cash and inventory management. At the same time, it is not beneficial for a company to have a very high working capital, much higher than the industry’s standard, as this means that cash is not being properly invested, or an unnecessarily high value of inventory is being held.