Working Capital represents the firm’s holdings of assets like cash, marketable securities, receivables, etc. Funds, being the backbone of any efficient business, are the most important aspect to be managed. Careful maintenance of the working capital and fund mix to acquire are key areas of decision-making and are important as they help to meet any business contingencies.
From an accounting perspective working capital is the difference between the short-term sources of funds, i.e., the current assets, and the short-term financial obligations, i.e., the current liabilities. In this article, we are providing you with all the information regarding working capital and its formula, components, and limitations.
What is Working Capital?
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Working Capital
Working capital can be called short-term finance. It is the amount normally available to any business so that they can finance day-to-day business operations and current activities. The primary objective of working capital is to enable an enterprise to maintain cash flows to meet its day-to-day financial obligations. Working capital has two different meanings from the perspective of value.
First is the gross working capital, and here, the enterprise’s working capital is represented by the total investment in current assets. Secondly, net working capital, and here, an enterprise’s working capital is denoted by the difference between current asset holdings and current liability holdings.
Business stakeholders consider positive working capital as an important indicator to judge a company’s financial well-being. For any company to stay in the market, they need to remain solvent in the long run. Even accounting ratios are calculated based on a mix of working capital, current assets, and current liabilities.
Components of Working Capital
Working capital is required for an entity so that the organization operates effectively and efficiently by monitoring and deploying its current assets and current liabilities to the best possible extent. It is important to take into account the two terms, current assets, and current liabilities, as we will be talking about this frequently in our discussion.
- Current Assets: Those assets that are easily converted into cash or have high liquidity are called current assets, and these assets are held by businesses to be converted into cash within 12 months or one normal operating cycle. Examples: cash, marketable securities, debtors, bills receivable, bank balance, short-term investments, inventory, etc. The holding of capital assets suggests the healthy financial well-being of a business, as it helps to finance the day-to-day business functions. Current assets are normally used to pay out current liabilities.
- Current Liabilities: Those liabilities or financial obligations that are required to be paid or due within 12 months or within one normal operating cycle of a business are known as current liabilities. Examples: creditors, bank overdrafts, bills payable, loans to be paid within 12 months, etc. Current liabilities are incurred to maintain regular business operations, like purchasing goods on credit, which creates a creditor. When a business is facing a cash crunch, it takes a bank overdraft to finance its operations.
Formula for Working Capital
Working capital is a key indicator of a company’s financial position and liquidity, which provides business stakeholders with an eagle-eye view of the company’s performance and helps them in their decision-making. The following is the formula to calculate working capital:
Working Capital = Current Assets – Current Liabilities
Let’s take a working capital example to understand this concept.
Case: GFG Pvt. Ltd., a company involved in providing technical consultancy services. The following figures were disclosed in their financial statement:
- Current assets, including marketable securities worth ₹12,50,000,
- Current liabilities amount to ₹8,00,000.
You are required to calculate the working capital of GFG Pvt. Ltd. and comment on the result.
Solution: Working Capital = Current Assets minus Current Liabilities
Working Capital = ₹12,50,000 – ₹8,00,0000
Working Capital = ₹4,50,000
This suggests that GFG Pvt. Ltd. has an excess of current assets over current liabilities by ₹4,50,000. Also, they can pay off their current dues and finance their day-to-day business obligations.
Significance of Working Capital
Negative working capital suggests that the company’s current assets are not sufficient to pay off current liabilities, and the company has more short-term debt than its short-term resources. Negative working capital is an indicator of poor short-term health, low liquidity, and a cash crunch.
Positive working capital suggests that the company’s current assets are greater than its current liabilities. The company has an excess of short-term resources over its short-term debt. Positive working capital suggests high liquidity and better financial well-being, as it is one of the indicators used by stakeholders to assess the financial well-being of a company.
Advantages of Working Capital
Positive working capital indicates that a company can fund its current operations and invest in future activities and growth, and it also shows the company’s operational efficiency and short-term financial health. The major advantages of working capital are as follows:
- Solvency: Adequate working capital helps in maintaining the solvency of the business by providing an uninterrupted flow of production.
- Goodwill: Sufficient working capital enables a business concerned to make prompt payments and hence helps in creating and maintaining goodwill, as maintaining adequate working capital gives stakeholders confidence in the company.
- Easy Loans: A concern having adequate working capital, high solvency, and good credit standing can arrange loans from banks and other sources on easy terms, as healthy working capital suggests a better financial position.
- Regular Supply of Raw Materials: Sufficient working capital ensures a regular supply of raw materials and continuous production.
- Regular payment of wages: Adequate working capital ensures that workers get regular payments, which helps them boost their morale and ensure uninterrupted production.
- Ability to Face Uncertainty: It enables a concern to face business crises in emergencies such as volatile markets, uncertain market forces, etc. because during such periods, generally, there is much pressure on working capital.
Limitations of Working Capital
Working capital can be a very useful indicator of a business’s immediate health. However, the method has significant drawbacks that can render the statistics occasionally inaccurate.
- Although positive working capital is a healthy indicator of a company’s financial well-being, idle surplus doesn’t earn any interest income or return.
- It is not static; it doesn’t remain the same during any period. Hence, by the time the working capital analysis is derived, the working capital of the company may have changed.
- Working capital does not consider the underlying types of accounts. For example, if a company has 100% of its current assets in debtors, its working capital will be shown as positive, but its financial outcome will depend on the realization of debtors.
- As working capital depends on current assets and current liabilities, some components of current assets and current liabilities are based on market conditions, and their realizable value is not constant, so the value of a company’s assets can change quickly. Therefore, the working capital will also change accordingly.
FAQs on Working Capital
What is working capital?
The business’s net working capital is the sum that remains after subtracting current liabilities from current assets. The indicator of a venture’s liquidity is working capital.
How can a company improve its working capital?
Increasing current assets will help a business’ working capital. This includes putting money aside, increasing inventory reserves, paying bills in advance, particularly if doing so results in a cash discount, or carefully deciding which clients to issue credit to (in an effort to lower its bad debt write-offs).
Does maintaining high working capital increase the financial well-being of the company?
No, maintaining high working capital is not optimal for any company. If any company keeps high working capital, the cost of keeping the funds will go up, returns will go down, and profitability will be affected.
What does negative working capital suggest?
Negative working capital suggests that the company is not able to finance its day-to-day business operations, and every financial commitment will now be sourced by current liabilities, which creates a debt trap for any company, and this doesn’t highlight financial well-being.
What are the factors that affect the working capital?
The changes in technology, seasonal or cyclical fluctuations, the length of the production cycle, the availability of credit, customers’ payment practises, and the anticipated development and expansion of a firm are the factors that affect working capital.
What is a normal operating cycle?
It is the time taken to convert sales after the conversion of resources into inventories into cash. It’s basically the acquisition of resources, the manufacture of the product, and finally the sale of the product.
What are the advantages of maintaining adequate working capital?
financial well-being, ability to tackle uncertainty, regular supply of raw materials, regular payment to vendors, etc.
Why is working capital important?
Working capital is used to fund operations and meet short-term obligations. If a company has enough working capital, it can continue to pay its employees and suppliers and meet other obligations, such as interest payments.