What is Working Capital?
A company’s working capital represents its residual current assets after deducting all its current liabilities. In other words, it is the difference between its current assets and current liabilities. Current assets usually comprise of accounts receivable, inventory, and cash. On the other hand, current liabilities may include accounts payable, overdraft, short-term loans, etc.
A company’s working capital plays a vital role in its success and survival. By managing its working capital, the company can ensure its liquidity and avoid cash flow problems. Therefore, working capital is crucial in a company’s liquidity. It is also a measure of the operational efficiency and short-term financial health of a company.
Companies always aim to have positive working capital. Therefore, they ensure they have sufficient current assets to meet their current liabilities demands. However, if a company possesses large quantities or amounts of working capital for a long time, it can also be problematic. Similarly, if a company’s working capital goes negative for a long time, it can raise some issues.
How to calculate a company’s Working Capital?
The calculation of working capital is straightforward. As mentioned, it is the residual amount after deducting a company’s current liabilities from its current assets. Therefore, the working capital formula will be as follows.
Working Capital = Current Assets – Current Liabilities
A company may expand the above formula according to its current assets and liabilities. For example, for a sample company, the formula for working capital will be as follows.
Working Capital = (Accounts receivable + Inventory + Cash) – (Accounts Payable + Short-term loans)
As mentioned, at any point, the above formula may result in a positive or negative figure. If the result is positive, it means that the company’s current assets exceed its current liabilities. For negative working capital, the opposite will apply.
Example
A company, White Co., has the following current assets.
Current Assets | |
Accounts Receivable | $ 50,000 |
Inventory | $ 40,000 |
Cash | $ 20,000 |
Total | $ 110,000 |
Similarly, it has the following current liabilities.
Current Liabilities | |
Accounts Payable | $ 45,000 |
Overdraft | $ 5,000 |
Short-term loans | $ 30,000 |
Total | $ 80,000 |
Therefore, the White Co.’s working capital will be as follows.
Working Capital = Current Assets – Current Liabilities
Working Capital = $110,000 – $80,000
Working Capital = $30,000
Since White Co.’s working capital is positive, it means that its current assets can cover its current liabilities.
What is the importance of Working Capital?
Companies need to maintain adequate working capital to stay in business in the long run. There are various reasons why it is crucial to do so. Among these reasons, some are below.
- It helps in the efficient running of operations.
- It enhances a company’s liquidity and solvency position.
- It can improve a company’s credit-worthiness.
- It improves a company’s goodwill.
- It can help avoid late payments.
- It assists in meeting contingencies.
- It ensures shareholders get timely dividends.
- It can help in cash flow management.
Aside from these, having an adequate level of working capital can provide several other benefits as well.
Conclusion
Working capital is a term used to describe the difference between a company’s current assets and current liabilities. It plays a vital role in a company’s success and survival. Positive working capital is always preferable to companies. It is because it indicates they have enough current assets to cover their current liabilities.