Working capital refers to the liquidity for maintaining day to day expenses of a company and cover inventory, cash, accounts payable, current liabilities which is not been paid yet.
What is Working Capital?
The working capital is the sum of money that is required for day to day operations of a company. Working capital measures a company's liquidity, operating efficiency and short term financial position.
The working capital means that a company has sufficient current assets such as cash, inventory, bills receivable to meet its current liabilities such as bills payable, taxes.
Working capital is more than the industry standard that the company is considered good. Low working capital may change the risk of bankruptcy.
What is the Working Capital Formula?
The working capital formula is simple. Working capital is obtained by deducting the current liabilities from current assets. The current assets and current liabilities can be found on the balance sheet of a company. Look at the working capital formula below,
Current assets are those assets that are to be converted into cash within a financial year. Some current assets are cash, bills receivable, inventory etc.
Current liabilities are those liabilities that are to be paid off within one year. Some examples of current liabilities are accounts payable, wages, taxes payable, dividends etc.
Working Capital Example
Assume it is an ABC company. Here is some information about ABC company.
The balance sheet for company ABC Year ended on 31 March 2019
| Particular | Amount (Rs) |
|---|---|
| Non-current assets | |
| Fixed assets | 425,000 |
| Long term investments | 390,000 |
| Total non-current assets | 815,000 |
| Current assets | |
| Cash in hand | 20,000 |
| Bills receivable | 50,000 |
| Inventory | 250,000 |
| Prepaid expenses | 100,000 |
| Short term loans | 200,000 |
| Total current assets | 620,000 |
| Total assets | 14,35,000 |
| Equity | |
| Share capital | 600,000 |
| Reserve | 330,000 |
| Total equity | 930,000 |
| Non-current liabilities | |
| Debentures | 200,000 |
| Long-term loans | 150,000 |
| Total non-current liabilities | 350,000 |
| Current liabilities | |
| Bills payable | 50,000 |
| Overdraft | 100,000 |
| Short-term loans | 5,000 |
| Total current liabilities | 155,000 |
| Total equity and liabilities | 14,35,000 |
Working Capital = 6,20,000 - 1,55,000
Working Capital = Rs. 4,65,000
The working capital of this company is positive.
Positive vs. Negative Working Capital
Positive working capital may indicate that the company's short term financing is good. Hence, the company already has enough liquidity assets to pay off its short term liabilities. Also positive working capital indicates that the company has more chances to grow in future.
A company with negative working capital means the company is not utilizing its efficiency and the company's current assets do not cover its current liabilities, then many have chances to go bankrupt.
What is the difference between Working Capital and Fixed Capital?
Working capital measures the liquidity of a company to run the company on a daily basis.
Fixed capital is also known as fixed assets. Fixed capital is not liquid assets and companies hold it over the long term.
Fixed capital is an investment of a company that gives the benefit over the long term. This investment can be plant, machinery, equipment, building and product line.
What is caused by changes in the Working Capital of a company's cash flow?
When companies come with new projects such as expansion in business, enter the new market etc. require a huge investment in working capital and that reduces the cash flow.
If a company's sales volume reduces that may be the reason for the fall in accounts receivable. Therefore, companies used working capital to improve cash flow.
What are the causes of change in Working Capital?
Here are several reasons that changes in the working capital of a company are given below.
1. Credit Policy
If a company follows a strict credit policy, which shrinks the amount of outstanding accounts receivables and it negatively impacts sales.
Conversely, if a company follows a relaxed credit policy, it will increase the outstanding accounts receivable.
2. Inventory Planning
In expectation of sales growth, a company would raise its inventory level. Hence, Investment will be increased and used cash. Shrinking inventory levels would reverse the impact.
3. Purchasing
If a company will reduce its unit costs by purchasing materials in heavy volumes. So, the heavy volumes increase the investment in inventory, as a result, more cash will be used. Similarly, buying in lower qualities impacts inversely.
4. Accounts Payable
If a company will delay paying its vendors, suppose the time shifts from 30 days to 45 days to free up cash and impact the working capital.
Frequently Asked Questions
1. What is Net Working Capital?
The networking capital is the difference between current assets and current liabilities of a company that measures the liquidity and ability to cover current liabilities with its current assets of a company.
It gives an idea of the financial position of a small company. The formula of net working capital is just like working capital.
2. How to calculate Net Working Capital?
The networking capital is calculated by subtracting current liabilities from the current assets. The formula is given below,
Let's understand with an example. Suppose a company has current assets of Rs. 5,00,000 and current liabilities of Rs. 3,50,000
Net Working Capital = Rs. (5,00,000 - 3,50,000)
Net Working Capital = Rs. 1,50,000
The company has positive net working capital of Rs. 1,50,000. The company can pay all the short term liabilities using the current assets. Hence, the company runs the business efficiently.
3. How to calculate Working Capital?
The calculation of working capital is simple. The working capital is calculated by deducting current liabilities from current assets.
Current assets include cash, accounts receivable, and inventory. Current liabilities include accounts payable, short-term debt payments.
For example, a company has Rs. 8,00,000 in current assets and its current liabilities are Rs. 3,00,000. The working capital of a company would be Rs. 5,00,000.
