What is working Capital?
Capital is another word for money. All businesses in order to purchase assets and maintain their operations or to produce goods and services must have capital. In the most basic terms, ‘Capital’ is the money invested in a business to generate income. Instead of simply spending it like cash, capital is a more durable concept and it is used to generate wealth through investment. The term ‘Working Capital’ is a part of total capital used (or more technically capital employed) in the business, but it comprises of short term assets and short term liabilities only. ‘Working Capital’ is often defined as the difference between short-term assets and short-term liabilities. In simple words, working capital denotes a ready amount of fund available for carrying out the day-to-day activities of a business enterprise. Capital is the means of investments of an enterprise with long term consequences, whereas working capital is that part of capital used for short term financing like routine operations or for a term not exceeding one accounting period.
Importance of Working Capital in Your Business
Without working capital, you wouldn’t be able to stay in business. A business uses working capital in its daily operations. Any business should have adequate funds to continue its operations and it should have sufficient funds to satisfy both maturing short-term liabilities and upcoming operational expenses. Working capital is a common measure of a company's liquidity, efficiency, and overall health. It is actually a yardstick that measures whether or not the company has enough assets to turn into cash to pay upcoming expenses or debts. Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and other short-term accounts. A company's working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection, and payments to suppliers.
How Working Capital is Calculated
Thus, ‘working capital’ is the difference amount between short-term assets and short-term liabilities. To understand this clearly we must have an idea on what are the ‘short term assets’ and ‘short term liabilities. Assets are a company's resources— a useful or valuable things that the company or person owns and which give some economic benefit to a business. Examples of assets (both long term and short term) include cash, accounts receivable, inventory, prepaid insurance, investments, land, buildings, plant and equipment, and goodwill, etc.
Current assets are short term assets only either in the form of cash or a cash equivalent which can be liquidated immediately or within an accounting period. Examples of current assets are cash in hand and bank, debtors, bills receivable, short-term investments, etc.
Liabilities (both long term and short term) are the obligations or what a business owes to the outsiders. It results from purchasing of goods on credit, bank loan, payable accounts like salary payable, taxes due, etc. Current liabilities are short-term liabilities only of a business which are expected to be settled within 12 months or within an accounting period or a normal operating cycle. Examples of current liabilities are bank overdraft, creditors, bills payable, short term loan, etc.
Working capital is calculated by subtracting current liabilities from current assets. Working capital is the easiest of all the balance sheet calculations to calculate. Here's the formula you'll need:
Working capital = Current assets - Current liabilities
It's that simple. If current assets are greater than current liabilities, the company has a positive working capital, meaning it has extra cash on hand to fund growth projects. It also means the company has a nice safety net in place.
Say, from a company's balance sheet we find that a company has $1000 in the bank, $500 as cash in hand, $5000 as inventory and & $500 receivable from customers. Then its total of current asset is $7000. Now similarly, its balance sheet shows that the company owes $2000 to its suppliers, and it has short term loan amounting $1500. So the total current liability of the company is $3500. Therefore, the Working Capital of the company is $ (7000-- 3500) or $3500.
Why Working Capital Management Matters
If we divide the current assets of a company by its current liabilities, we get a figure which is called ‘Current Ratio’ (or working capital ratio). This ratio attempts to measure the ability of a firm to meet its current obligations. It can be used to make a rough estimate of a company’s financial health. Normally, a ratio much higher than 2 (i.e., current assets double the current liabilities) is a sign that you’re not properly using your funds – either you are carrying too much inventory or not capitalizing on extra cash by investing in growing your business. On the other hand, a Current Ratio below 1 suggests that the company may not be able to meet its obligations in the short run. Each business or industry might have its own ideal current ratio depending upon its practice. Acceptable current ratios vary from industry to industry and are generally considered between 1.5 and 3 for healthy businesses.
Hope this Blog post will help you to understand the importance of working capital and guide you to manage it effectively in your business. However, if you are overburdened with other responsibilities, or need some real professional assistance, we can help demystify and help navigate constant change.
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Written by: Jag Bath