WORKING CAPITAL: HOW IT IS CALCULATED, IMPORTANCE AND EXAMPLE - DUDAS - 2025

The working capital, also known as working capital is a financial indicator that represents operating liquidity available to a company, organization or other entity, including government entities. Like fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

The working capital is the difference between the current assets of a company, such as cash, accounts receivable from customers, inventories of raw materials and finished products; and current liabilities, such as accounts payable to suppliers.

Most projects require an investment in working capital, which reduces cash flow, but cash will also decrease if money is raised too slowly or if sales volume is decreasing, causing accounts to drop. receivable.

Working capital reveals a lot about the financial condition of a company, or at least the liquidity position of that company in the short term.

How is it calculated?

Working capital is calculated by subtracting current assets from current liabilities:

Working capital = current assets - current liabilities

If current assets are less than current liabilities, the company has a working capital deficiency, also called a working capital deficit.

Current assets and current liabilities include three accounts that are of particular importance. These accounts represent the areas of the business where managers have the most direct impact: accounts receivable and inventory (current assets), and accounts payable-current liabilities.

The current portion of debt (payable within 12 months) is critical because it represents a short-term claim on current assets. Other types of short-term debt are bank loans and lines of credit.

Formula features

The working capital formula assumes that a company would actually liquidate its current assets to pay current liabilities, which is not always realistic, considering that some cash is always needed to meet payroll obligations and maintain operations.

Additionally, the working capital formula assumes that accounts receivable are available for collection, which may not be the case for many companies.

A positive working capital cycle stabilizes income and payments to minimize working capital and maximize cash flow.

Growing companies require cash. The cheapest way to grow is to be able to free up cash by shortening the working capital cycle.

Importance

Working capital is a common indicator of the liquidity, efficiency, and overall health of a business. A company can be endowed with many assets and profitability; however, you may be illiquid if your assets cannot easily be converted to cash.

The working capital reflects the results of a series of activities of the company. Includes inventory management, debt management, revenue collection, and supplier payments.

It is more reliable than any other financial indicator, because it indicates what would be left if a company took all its short-term resources and used them to pay all its short-term liabilities. The more working capital a business has available, the less financial stress it will experience.

One of the most important uses of working capital is inventory. The longer the inventory is in stock, the longer the company's working capital will be immobilized.

Positive and negative working capital

One of the main benefits of looking at a company's working capital position is being able to anticipate many potential financial difficulties that may arise.

Positive working capital is required to ensure that a company can continue to operate, as well as that it has sufficient funds to pay off both operating expenses and short-term debts almost immediately.

Negative working capital generally indicates that a company cannot meet its short-term debts.

However, a company that maintains too much working capital can reduce its returns. An investor might be better off if the board of directors decided to distribute part of that surplus in the form of dividends; therefore it could be a misleading assessment.

The need for cash

When not managed carefully, businesses can grow out of cash, requiring more working capital to meet expansion plans than they can generate in their current state.

This generally occurs when a company has used cash to pay for everything, rather than seeking financing that smoothes payments and makes cash available for other uses.

As a result, a lack of working capital causes many businesses to fail, even though they actually make a profit. The most efficient companies invest wisely to avoid these situations.

As an absolute rule of thumb for financiers, they want to see positive working capital. Such a situation gives them the possibility of thinking that the company has sufficient current assets to cover its financial obligations.

Increase and decrease in working capital

By studying working capital levels, you can determine if a company has the resources to expand internally or if it will need to turn to financial markets to raise additional funds.

In the best of circumstances, insufficient levels of working capital can put financial pressures on a business. This increases loans and the number of late payments to creditors and suppliers.

This is the reason why analysts are sensitive to a decrease in working capital, as it indicates that a company is having difficulty maintaining or increasing its sales, is paying bills too quickly, or is collecting accounts receivable too slowly..

On the other hand, an increase in working capital suggests otherwise. Indicates that the company has increased its current assets or decreased current liabilities; for example, you have paid off some short-term creditors.

There are several ways to further assess a company's working capital. Inventory turnover, accounts receivable and payable days ratio, current ratio and acid test are included.

Example

Here is the balance sheet information on Company XYZ:

Using the working capital formula and the balance sheet information in the table above, we can calculate that the working capital of company XYZ is:

$ 160,000 (total current assets) - $ 65,000 (total current liabilities)

= $ 95,000 (working capital)

References

1. Investopedia (2018). Working Capital. Taken from: investopedia.com.
2. Wikipedia, the free encyclopedia (2018). Working capital. Taken from: en.wikipedia.org.
3. InvestingAnswers (2018). Working Capital. Taken from: investinganswers.com.
4. Joshua Kennon (2018). How to Calculate Working Capital on the Balance Sheet. The Balance. Taken from: thebalance.com.
5. Graydon (2018). Working Capital. Taken from: graydon.co.uk.