Working capital is the money needed to fund the normal, day to day operations of your business. It ensures you have enough cash to pay your debts and expenses as they fall due, particularly during your start-up period. It measures how much in liquid assets a company has available to build its business. The number can be positive or negative, depending on how much debt a company is carrying. In simple meaning, working capital is the difference between current assets and current liabilities of a company.
Working capital (WC) = Current Assets (CA) – Current Liabilities (CL)
Current assets are the most liquid of your assets, meaning they are cash or can be quickly converted to cash. Current liabilities are any obligations due within one year. Working capital measures what is leftover once you subtract your current liabilities from your current assets and can be a positive or negative amount. In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller. The working capital is available to pay company's current debts and represents the cushion or margin of protection you can give your short-term creditors.
Working Capital is a common measure of a company's liquidity, efficiency and overall health. Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year and other short-term accounts, a company's working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection and payments to suppliers.
Analysts commonly point out that the level and timing of a company's cash flows are what really determine whether a company is able to pay its liabilities when due. Thus it also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner i.e. unable to collect with debtors timely, it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.
Working Capital Cycle:-
The working capital cycle (WCC) is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, companies strive to reduce its working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. It is made up of four components – Cash, Creditors, Inventory and Debtors.
Working Capital Management:-
Decisions relating to working capital and short term financing are referred to as working capital management. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. Now the question is what’s the right level of working capital? The right level of working capital depends on the industry and the particular circumstances of the business. For instance: Businesses that only sell services and do not need to pay cash for inventory need a lower level of working capital. Businesses that take a substantial amount of time to make of sell a product will need a higher level of working capital.
It is important you work out the right level of working capital you will need. If the working capital is too:
a) high - business has surplus funds which are not earning a return; and
b) low - may indicate that your business is facing financial difficulties.