Define Working Capital : Example, Importance, Concept

 

What is Working Capital, and Why is it important?

Define Working Capital Example Importance Concept

Working capital may be defined as the difference between a company’s current assets and current liabilities. It is a financial metric that determines whether or not a firm has sufficient liquid assets to pay its payments that are due within a year. When a firm has surplus current assets, the money in those assets can be utilized to fund the company’s day-to-day business activities.

  • Current Assets 

Current assets, which include cash and cash equivalents, inventory, accounts receivable, and marketable securities, are resources that a firm has that may be used up or converted into cash within a year of acquisition or acquisition.

  • Current Liabilities 

Currently owing money to a firm includes accounts payable, short-term loans, and accumulated costs. These obligations are required for payment within a year of the date of the invoice or receipt.

What are Current Assets ? Difference Between Current Assets vs Current Liabilities ?

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Positive And Negative Working Capital 

A company’s short-term financial health can be improved by having positive working capital because this indicates that the firm has sufficient liquid assets to pay short-term obligations and to internally finance the expansion of its operations. Because of a working capital shortage, a firm may be forced to borrow extra cash from a bank or resort to investment bankers to raise additional capital.

The absence of positive working capital indicates that assets are not being utilized efficiently, and a firm may be faced with a liquidity crunch. Even if a firm has a significant amount of money invested in physical assets, it will experience financial and operational difficulties if its responsibilities are not paid on time. This might result in the firm borrowing more money, making late payments to creditors and suppliers, and, as a result, receiving a worse corporate credit rating.

Concept of Working Capital 

Working capital is defined as the money that is used to purchase current assets (e.g., inventory). It is the fund that is required to carry out the day-to-day activities of the organization. It flows throughout the company in the same way as blood circulates across a living organism. Working capital, in general, refers to the current assets of a company that are converted from one form to another in the ordinary course of business, such as from cash to inventory, inventory to work in progress (WIP), WIP to finished goods, finished goods to receivables, and receivables to cash, among other things.

When it comes to working capital, there are two ideas to consider 

  • Gross working capital
  • Net Working capital

Gross Working Capital (GWC) is defined as the total of all current assets held by a corporate concern, less any debt. So, Gross working capital is equal to the sum of stock, debtors, receivables, and cash.

Net Working Capital (also known as net working capital) is the amount of money that is available for use. In business, net working capital is defined as the difference between current assets and current liabilities of a company’s financial statements. Hence, Net working capital is equal to the sum of stock, debtors, and receivables, plus cash minus creditors and payables.

The following is an explanation of the nature of working capital:

  •  It changes shape regularly to keep the wheels of commerce turning. 
  • Work in progress improves the liquidity, solvency, creditworthiness, and reputation of a business organization.
  • The cost factors that are generated are materials, labor, and costs.
  • It makes it possible for a business to take advantage of cash discount programs given by its suppliers. 
  • It assists in boosting corporate leaders’ morale and increasing their productivity to the maximum possible level.
  •  It enables the enterprise’s expansion plans while also assisting in the maintenance of operational effi¬≠ciency of fixed assets.

Working capital in accounting

The money that is currently accessible for use by your company for its day-to-day activities is referred to as working capital. Additionally, working capital serves as an excellent indication of overall financial health because it encompasses all of the following operations :

  • Revenue Collection 

In the case of a firm, the amount of income collected is represented in the amount of working capital available. Working capital reflects both the efficiency with which your income is received and the accuracy with which your revenue is recognized. Slow revenue collection can have a negative influence on cash flow, resulting in less cash available for satisfying current obligations.

  • Inventory management

 While it appears to be a straightforward task, inventory management may be a difficult one to master. Over-ordering inventory might leave you with less cash, which can have a negative influence on your net income. As a result, your company may wind up with a warehouse full of items that are unable to be sold. Under-ordering inventory may be just as damaging, with the possibility of missed sales when clients look elsewhere to acquire things that you do not currently have in store if you do not order enough inventory.

  • Accounts payable

 Unless you also have short-term notes due, your accounts payable account represents the majority of your current liabilities. You may use your accounts payable totals to gain a sense of your present cost of doing company, whether you’re putting together financial predictions for the next five years or inputting data for next year’s financial plan.

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How to Calculate working capital

The following is the formula for networking capital:

  • Net working capital is equal to the difference between current assets and current liabilities.

Using this method will assist you in calculating your total working capital. For example, if your current assets amount to $125,000 and your current obligations total $95,000, the following computation would be appropriate-  $125,000 minus $95,000.

You can use the following method to figure out how much working capital you have based on your accounting ratio:

  • Working Capital Ratio is defined as Current Assets minus Current Liabilities.

Working Capital Ratio is calculated as $125,000 minus $95,000 = 1.32. For every $1 in current obligations that you have, you have $1.32 in current assets that will be used to pay those liabilities down.

The working capital ratio formula is identical to the quick ratio formula, with the exception that it includes inventory, which the fast ratio formula does not include. This ratio evaluates a company’s total liquidity, including its capacity to pay off any short-term commitments with assets that are available in the short term.

Importance of Working Capital 

It is often claimed that working capital is the lifeblood of a company’s operations. Funds are required by any firm to carry out its day-to-day operations. The following examples will help you better understand the significance of working capital-

  •  It assists in determining the profitability of a business. Both output and profit would be impossible to achieve in its absence.
  • In the absence of appropriate working capital, a company will be unable to satisfy its short-term obligations on time.
  • Due to its excellent reputation or goodwill, a company with a strong working capital position may get loans from the market with no difficulty.
  • In addition to delivering raw supplies and making salary payments, having sufficient working capital helps to ensure that production continues continuously.
  • A healthy working capital position assists in maintaining an optimal level of investment in current assets.
  • The liquidity, solvency, creditworthiness, and reputation of the company are all improved as a result of this process.
  •  It offers the cash required to cover unexpected eventualities, allowing the business to continue operating effectively even during times of crisis.

What does your company’s working capital tell you about its operations?

Even though working capital is a straightforward calculation, the amount may reveal a great deal about the health of your company. The fact that your firm has a working capital ratio of less than one implies that your company is experiencing significant liquidity difficulties and does not have enough current assets to cover current liabilities, for example.

It can also communicate to potential investors and financial institutions that your firm is solid and functioning within its financial capacity to meet any impending obligations. The following are some more things that working capital may tell you about your business:

  • Whether or not  you need to make adjustments

As a business owner, you are accountable for everything, from making sure the rent is paid on time to ensuring that your employees’ paychecks do not go into default. Your working capital supplies you with the information you require to determine whether you will be able to meet all of your financial responsibilities for the future year or whether you will need to make adjustments to your operations.

  • Your company’s total liquidity is measured.

In addition to providing you with an idea of how your business is functioning, your cash flow statement and profit and loss statement are not reliable predictors of how financially secure your firm will be in the next year. The working capital ratio gives you an excellent indication of your company’s overall liquidity for the future year, and it is easy to calculate.

  • Health and well-being of your organization.

It is particularly crucial to potential investors and financial institutions with whom you may be interested in doing business that you have sufficient working cash. The seemingly straightforward working capital number or ratio may reveal a great deal about your company, particularly about how it will perform over the current fiscal year.

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