Working capital is the difference between the current assets and the current liabilities of a company. In simple words, it is the funds available to a business for its day-to-day operations. Auditors and managers use this financial metric to evaluate the short-term financial health of a business.
Read along to learn different aspects of working capital like its meaning, types, formula, and examples.
Table of Contents
What is working capital?
Working capital refers to the difference between a company’s current assets and current liabilities.
Current assets include cash and other assets like account receivables and inventory, which can be converted into cash within a year.
Current liabilities are those obligations that a company needs to clear within a year, such as accounts payable, payroll, etc.
A positive difference between current assets and liabilities means the company is in sound financial health. On the other hand, a negative working capital indicates that a business is required to pay more for its short-term financial obligations than what it has available as assets.
One of the major challenges for a company’s stakeholders is to ensure that the company is able to meet its daily operational expenses using the financial resources in an efficient manner.
However, one must remember that that are disadvantages of excessive working capital. Having an abundance results in unused funds that don’t generate profits for the business, thereby preventing the business from achieving a satisfactory return on its investments.
What is the formula of working capital?
The widely used formula is:
Working Capital = Current Assets – Current Liabilities
Examples of current assets include cash, inventories, marketable securities, accounts receivable, etc.
Examples of current liabilities include short-term dividends, accounts payable, income tax due, etc.
Alternative working capital formulas
- Working Capital = Current Assets – Cash- Current Liabilities (excluding cash)
Under this formula, you do not include cash in current assets rather use it separately to subtract from current liabilities. - Working Capital = Accounts Receivable + Inventory – Accounts Payable
Accounts receivable means the amount that the company owes from other entities. Accounts payable means what the company is obligated to pay. Inventory represents the value of goods that can be sold, contributing to revenue and potentially converted to cash. - Net Working Capital = Current Assets (excluding cash) – Current Liabilities (excluding debt)
The formula essentially calculates the net working capital by subtracting the current liabilities (excluding debt) from the current assets (excluding cash). This provides a more focused view of the working capital that excludes the impact of cash and long-term debt. - Operating Working Capital = Current Assets – Non-operating Current Assets
Non-operating current assets are those assets that are not part of the company’s core activities. Examples include spare machinery and equipment or unused land. - Change in Working Capital = Working Capital (Previous Year) – Working Capital (Current Year)
This formula is self-explanatory as it measures the change seen in the working capital compared to the previous year. It is a good indicator of a company’s improvement or deterioration in its financial health.
Also, one must understand the change in working capital formula to have a clearer understanding of the working capital requirements of a business. By tracking the differences across different accounting periods, businesses can reduce financial risks and focus on sustainability.
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What are the components of working capital?
The components include:
Current assets: Cash, accounts receivable, inventory, short-term investments, pre-paid expenses, and more.
Current liabilities: Wages payable, accounts payable, short-term loans and accrued liabilities.
It is crucial for a business to understand the key components of working capital to be fully able to manage it.
What are current assets in the working capital formula
Current asset refer to the short-term assets that a company expects to convert into cash or use up within one year. These assets are crucial for supporting day-to-day operational needs. Common examples of current assets include:
- Cash and cash equivalents:
a. Cash on hand: Physical currency held by a business
b. Cash equivalents: Highly liquid and short-term investments that are easily convertible to known amounts of cash and have a short maturity period (e.g., money market funds, treasury bills) - Accounts receivable: Amounts owed to the business by its customers for goods or services that have been delivered but not yet paid for.
- Inventory: The value of goods and materials held by a business, either finished goods ready for sale or raw materials for production.
- Short-term investments: Investments that can be quickly converted into cash, such as marketable securities or short-term bonds.
- Pre-paid expenses: These encompass the total worth of costs settled beforehand. While converting them into cash might pose a challenge in urgent cash requirements, they retain short-term value and are considered in the accounting process.
What are current liabilities in the working capital formula
Current liabilities are basically all debt that a business owes. These need to be paid back within 12 months. It also consists of debt that is owed over the next 12 months. Let’s look at a few examples:
- Wages payable
Wages and salaries that a business needs to pay to its employees during the year form a part of current liabilities. As all businesses pay monthly pay checks, wages payable contain one month’s salary only.
- Accounts payable
This includes unpaid invoices to suppliers and vendors, utility bills, rent, property taxes, and any other payment owed to a third party.
- Dividend payable
It is the authorised dividends that a business/company is obligated to pay to its shareholders.
- Present portion of long-term loans
This means all the payments that a business needs to make within the next 12 months with respect to any long-term debt. Suppose a business has a long-term debt of 8 years. All EMIs paid in the next 12 months with respect to servicing this debt will come under the current liabilities section.
- Accrued tax
Direct and indirect tax obligations for the current year also form a part of current liabilities for the business. It is a future obligation that the company needs to make within one year.
Working capital explained with examples
The major objective of working capital is to help business owners understand whether their company will be able to service all its short-term obligations with the short-term assets it has.
Suppose the total value of current assets of a business for the year 2022-23 is Rs. 320 crores. It represents short-term sources of revenue for the company. Current assets of the company include cash and other equivalents, accounts receivables, and inventory.
On the other hand, suppose the total value of current liabilities for the company in the year 2022-23 is Rs. 250 crores. It includes accounts payable, wages, tax accrued, and dividends payable. This represents obligations that the company needs to pay in the year 2022-23.
Working Capital = (320 -250) = Rs. 80 crores.
Also read: Top 5 Working Capital Examples
Why is working capital important?
- Operational stability: Adequate working capital ensures a company’s ability to cover its short-term operational expenses, such as payroll, utilities, and raw material purchases. It contributes to the smooth functioning of day-to-day business operations.
- Cash flow management: It helps in managing cash flow effectively by ensuring that there is enough liquidity to meet short-term obligations. This is crucial for preventing disruptions in the production and sales processes.
- Supplier and creditor relationships: Maintaining a positive working capital allows a company to honour its commitments to suppliers and creditors on time. This fosters good relationships with business partners and can lead to favourable terms.
- Flexibility for opportunities: Positive working capital provides a financial cushion, allowing a company to seize opportunities, such as taking advantage of vendor discounts, investing in growth initiatives, or navigating unexpected expenses.
- Investor confidence: Investors often assess this financial metric as an indicator of a company’s financial health. A positive working capital position can enhance investor confidence, reflecting the company’s ability to meet its short-term obligations.
- Seasonal fluctuations: Working capital management is crucial for businesses with seasonal fluctuations. It allows them to navigate periods of reduced revenue without facing immediate financial strain.
Also read: Understanding Working Capital Management: An Immersive Guide for SMEs - Risk mitigation: A well-managed working capital mitigates the risk of insolvency or bankruptcy. It provides a financial buffer, reducing the likelihood of defaulting on obligations.
- Financial planning: Working capital analysis assists in effective financial planning by identifying trends and patterns in a company’s cash conversion cycle. This insight helps in optimizing inventory levels and credit terms.
Positive Working Capital vs. Negative Working Capital:
Positive working capital:
- Indicates that a company has more current assets than current liabilities.
- Implies the ability to cover short-term obligations and invest in growth opportunities.
- Reflects operational efficiency and financial health.
- Occurs when current liabilities exceed current assets.
- May suggest potential liquidity challenges, especially if not managed properly.
- In certain industries, negative working capital is acceptable, such as retail where products are sold before payment to suppliers is due.
What are the different types of working capital?
The different types of working capital are as follows:
- Gross working capital: It represents the total current assets of the company. Cash and cash equivalents, account receivables, and short-term revenues are some examples. It does not include current liability. Understanding gross working capital is paramount for any business aiming for efficient financial management.
- Net working capital: It is the difference between a company’s current assets and current liabilities. It provides a measure of a company’s ability to meet its short-term obligations and represents the liquidity available for day-to-day operations.
- Permanent working capital: It is the minimum level of working capital required by a company to sustain its ongoing operations. It represents the baseline amount needed for regular business activities.
- Temporary working capital: It is the fluctuating or variable part of working capital that arises due to seasonal variations, short-term projects, or other temporary factors. It is the difference between total working capital and permanent working capital.
- Regular working capital: It is the working capital that a company needs to function and fund its daily activities. Regular working capital will take care of salaries, wages, payment for raw materials, and transportation costs.
- Reserve margin working capital: refers to an additional amount of working capital held by a company as a buffer or safety margin. It provides extra liquidity to address unforeseen circumstances or business uncertainties.
- Variable working capital: includes the temporary and fluctuating components of working capital that vary with changes in business activities, production levels, or seasonal demand. There are two subcategories of variable working capital:
a. Seasonable variable working capital: It is invested in the business seasonally when the requirements of funds are high.
b. Special variable working capital: As the name suggests, special variable working capital is for special cases only. They are used for specific, non-routine projects or activities that go beyond the regular business operations.
To get a detailed understanding, also read: Capital Fuel: Types of Working Capital Explained
Advantages of efficient working capital management
- Enhanced cash flow management: Efficient working capital management contributes to improved cash flow, enabling businesses to meet their day-to-day financial obligations seamlessly. This proactive approach helps prevent cash shortages and ensures the liquidity necessary for smooth operations.
Also read: Understanding Changes in Working Capital and Its Impact on Cash Flow - Financial stability in emergencies: Working capital acts as a financial safety net, allowing businesses to address unexpected or emergency expenditures without jeopardising their financial stability. This flexibility is crucial for navigating unforeseen challenges or seizing sudden opportunities.
- Facilitates strategic investments: With adequate working capital, businesses have the flexibility to explore new opportunities and invest in research and development initiatives. This strategic use of funds can foster innovation, market expansion, and long-term growth.
- Resilience and shock absorption: Maintaining a positive working capital position empowers a business to demonstrate resilience in the face of financial shocks. It provides a buffer against economic downturns, market fluctuations, or unexpected disruptions, enhancing the company’s ability to weather uncertainties.
- Catalyst for business growth: Positive working capital provides the foundation for business growth. It supports expansions, acquisitions, and capital investments, empowering companies to capitalise on strategic opportunities and stay ahead in competitive markets.
- Enhances creditworthiness: A strong working capital position enhances a company’s creditworthiness. Lenders and investors view it as a sign of financial health and stability, making it easier for the business to secure favourable financing terms and attract investment.
By considering these facets, businesses can not only manage their day-to-day operations effectively but also position themselves for long-term success and resilience in a dynamic business environment.
Disadvantages of excessive working capital
While having sufficient working capital is crucial for the smooth operation of a business, there are disadvantages of excessive working capital. Businesses need to strike a balance in managing working capital to ensure that they have enough liquidity to cover short-term obligations without tying up excessive funds that could be utilised more efficiently elsewhere. Continuous monitoring and adjustment of working capital levels are essential for optimising financial performance.
How to increase working capital?
Here are some ways by which a business can improve its working capital:
- Businesses have the option to pursue long-term debt, a strategic move that enhances cash reserves and consequently enhances current assets. However, it’s noteworthy that this doesn’t impact current liabilities, which remain unchanged.
- Businesses can optimise their financial structure by converting short-term debts into long-term obligations. This approach provides the company with extended repayment timelines, alleviating pressure on current liabilities.
- Another way of increasing the portion of the current assets is by selling illiquid assets. The cash that will be earned will increase current assets and working capital.
- Effective management of current liabilities involves a keen focus on expense control. Cutting down on unnecessary expenditures is pivotal in containing current liabilities, reinforcing financial stability.
- Better inventory management also helps so that it is not overstocked. It frees up cash and also prevents losses due to accidents or thefts.
What is working capital turnover ratio?
Working capital turnover ratio is a financial metric that helps business owners understand how well their company is using its working capital to generate sales. It’s calculated by dividing net sales by average working capital. Higher turnover implies better efficiency in using working capital to support sales.
Understanding working capital turnover ratio is important. As business owners, you must be aware that if this metric is not monitored regularly, there might be disruptions in cash flow for day-to-day operations.
What is operating cycle of working capital?
Operating cycle refers to the total number of working days that a business takes to buy inventory, sell it off, and then collect the proceedings from the sale.
If you wish to determine how efficiently a business is running, it’s the operating cycle of working capital you should be checking. It is important to note that all companies work towards maintaining a short working capital cycle.
FAQs
Q1: Is negative working capital bad?
While negative working capital may be perceived traditionally as a sign of financial distress, it is not universally considered “bad.” Negative working capital is more common in certain industries and business models where the cash is collected from customers before payments to suppliers are due.
Q2: What is a simple way to calculate working capital?
The most simple way to calculate working capital is by subtracting current liabilities from current assets.
Q3: What is a good working capital ratio?
No hard and fast rule determines a good or bad working capital ratio. However, in normal cases, a working capital ratio in the range of 1.5 to 2 is considered healthy.
Q4: What is the difference between gross and net working capital?
A gross working capital will always be positive whereas a net working capital can be either negative or positive depending on the health of the business.
Q5: What is change in working capital?
The change in working capital refers to the difference between the current period’s working capital and the working capital of the previous period. It is a measure that helps assess how a company’s short-term liquidity position has evolved over time.
Q6: What is the difference between working capital and net working capital?
Working capital is the difference between a company’s current assets and current liabilities. Net working capital is also the difference between current assets and current liabilities, but it excludes cash and cash equivalents from current assets.
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