What is Working capital?

(Last Updated On: March 9, 2022)

Working capital is a measure of a company’s liquidity and its ability to pay short-term debts. It is calculated as current assets minus current liabilities. A company with a lot of working capital can easily meet its short-term obligations, while a company with little working capital may have trouble paying its bills.

There are several components of working capital, including accounts receivable, inventory, and cash. Accounts receivable are amounts owed to a company by customers who have purchased goods or services on credit. Inventory is the amount of merchandise that a company has on hand. Cash is the amount of money that a company has in its bank account.

A company’s working capital can be increased by collecting more accounts receivable, selling more inventory, or increasing its cash balance. It can also be reduced by extending more credit to customers, buying more inventory, or reducing its cash balance.

Working capital is an important measure of a company’s financial health. It allows a company to pay its bills and continue operating. It is also a key factor in determining a company’s credit rating.

What are Current Assets

Before calculating working capital, let’s first define what current assets are assets that can be converted into cash within a year. Some examples of current assets include cash or cash equivalents, inventory, and accounts receivable. A company’s current assets are a good indicator of its liquidity, or how easily it can meet its short-term obligations. 

How to Calculate Working Capital

There are several ways to calculate working capital. The most common method is to subtract current liabilities from current assets. This gives you the company’s net working capital.

Another way to calculate working capital is to divide current liabilities by current assets. This gives you the company’s liquidity ratio.

The following examples will help you understand how to calculate working capital.

Example 1

Company A has the following current assets and liabilities:

  • Cash: $10,000
  • Accounts receivable: $12,000
  • Inventory: $8,000
  • Current liabilities: $4,000

Working capital = current assets – current liabilities

= $10,000 – $4,000

= $6,000

Example 2

Company B has the following current assets and liabilities:

  • Cash: $1,000
  • Accounts receivable: $10,000
  • Inventory: $5,000
  • Current liabilities: $3,000

Working capital = current assets – current liabilities

= $16,000 – $3,000

= $13,000

What is the working capital ratio?

The working capital ratio is a metric that measures how much a company’s current assets exceed its current liabilities. This ratio can be used to indicate a company’s overall financial health. A high working capital ratio usually indicates that a company is in good shape, while a low working capital ratio may indicate that the company is in trouble. The working capital ratio can be calculated by dividing a company’s current assets by its current liabilities. For example, if a company has $100,000 in current assets and $50,000 in current liabilities, its working capital ratio would be 2:1.

The working capital ratio is an important metric for business owners to monitor, as it can indicate whether a company is in good financial shape or not. By tracking the working capital ratio over time, business owners can get a better idea of how their company is doing financially. If the working capital ratio starts to decline, it may be a sign that the company is in trouble and needs to take corrective action.

In summary, the working capital ratio is a metric that measures how much a company’s current assets exceed its current liabilities. A high working capital ratio usually indicates that a company is in good shape, while a low working capital ratio may indicate that the company is in trouble. The working capital ratio can be used to indicate a company’s overall financial health.

Working Capital Management

Properly managing working capital helps better use a company’s current assets and maintain the cash flow needed to pay short-term debts. Additionally, this helps to free up cash that would otherwise be trapped on the balance sheet, allowing the company to invest that cash in other areas of the business. 

Working capital is a dynamic figure that can change on a daily, weekly, or monthly basis. A company’s working capital position can be affected by a number of factors, including seasonality, the business cycle, and changes in sales volume.

A company’s ability to manage its working capital is critical to its success. There are a number of ways to improve or worsen a company’s working capital position, including:

  • Collecting cash from customers quickly
  • Offering extended payment terms to customers
  • Paying suppliers quickly
  • Requesting longer payment terms from suppliers or creditors
  • Taking out short-term loans to cover expenses in the short term

What is net working capital (NWC)?

Net working capital is a calculation to measure a company’s operational efficiency.  To find this figure, calculate the difference between a company’s current assets and its current liabilities. This metric can be used to measure a company’s liquidity, or how easily it can meet its short-term obligations. A high net working capital indicates that a company has a lot of liquid assets, while a low net working capital means the company is not as liquid.

Net working capital can be calculated by subtracting a company’s current liabilities from its current assets. For example, if a company has $50,000 in current assets and $30,000 in current liabilities, its net working capital would be $20,000.

Business owners can use net working capital to measure how easily their company can meet its short-term obligations. If the net working capital starts to decline, it may be a sign that the company is in trouble and needs to take corrective action.

In summary, net working capital is the difference between a company’s current assets and its current liabilities. This metric can be used to measure a company’s liquidity.

Working Capital Financing Methods

Short-term loans: short-term loans are a type of debt financing that businesses can use to bridge the gap between their current liabilities and current assets. These loans typically have a shorter repayment term than long-term loans, and they can be used to finance a company’s day-to-day operations.

Lines of credit: A line of credit is a type of loan that allows businesses to borrow money as needed. A line of credit can be used to finance a company’s short-term needs, and it typically has a lower interest rate than a short-term loan.

Factoring: Factoring is a type of invoice financing that allows businesses to sell their accounts receivable to a third party for cash. This can be a helpful way for businesses to raise money quickly to cover short-term expenses.

Asset-based lending: Asset-based lending is a type of lending that is based on the assets of a company rather than its credit score. This type of lending can be helpful for businesses that have strong assets but may not have a strong credit score.

Working capital is a key part of any business, and it’s important for business owners to understand how their company’s working capital position changes over time. By understanding the different ways to improve or worsen a company’s working capital position, business owners can make sound decisions about how to better manage the short-term financial health of the business.

Why is Working Capital Important?

A positive working capital (or higher ratio) indicates that a company has more current assets than liabilities, while a negative working capital means the opposite. Negative working capital can be a sign of financial trouble for a business, while a positive working capital usually indicates that the company is in good shape financially.

A low working capital number, on the other hand, could signal that a company is having difficulty meeting its short-term obligations. This could be a sign of financial trouble and may lead to problems such as missed payments, supplier defaults, and bankruptcy.

In summary, working capital is important for a number of reasons:

  • It indicates a company’s financial health
  • A low working capital number can be a sign of financial trouble
  • A positive working capital usually indicates that the company is in good shape financially
  • It helps a company meet its short-term obligations
  • It can be used to finance a company’s day-to-day operations
  • Investors and lenders can compare a business’s current performance with prior quarters and compare the business with other companies

It’s important for business owners to understand how their company’s working capital position changes over time. By understanding the different ways to improve or worsen a company’s working capital position, business owners can make sound decisions about how to finance their business’ short-term needs.