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Working Capital Definition
Working capital is the measure of the liquidity available in a company with which the company funds its daily operations. Working capital is also called net working capital, it is the amount of liquidity left for a company after its current liabilities have been removed from the current assets.
The formula for calculating working capital is (Current Assets – Current Liabilities). Current assets include cash, accounts receivable, inventories of raw materials and others. Account payable is an example of a company’s current liabilities. Using a financial metric (working capital), the amount of liquidity that serves as a company’s operating capital is calculated.
A Little More on What is Working Capital
The working capital ratio indicates the capital (money) available for a company to run its daily operations. The working capital ratio is arrived at when the difference between current assets and current liabilities is calculated. A ratio of 1.0 – 2.0 is an indication that a company has a good operating capital while a ratio less than 1.0 represents a poor or negative working capital. Also, a company is said not to effectively use its excess assets if it has a ratio above 2.0.
Financial analysts often pay attention to a company’s working capital ratio. Peradventure a company’s current asset is lower than its current liabilities, there is a risk of insolvency and bankruptcy.
Certain factors are responsible for changes in a working capital. Generally, the ratio is not static for most companies but a company’s ability to adequately manage its current assets and current liabilities will determine what type of changes will occur to the working capital ratio.
Since a company’s operations depend on working capital for survival, changes in the working capital can affect a company’s cash flow, either positively or negatively. Decline in a company’s sales can cause a decrease in accounts receivable which will affect cash flow. Certain companies that do not use working capital well not adopt other measures in enhancing positive cash flow.
A working capital ratio below 1.0 is an indication that a company has a bad working capital. However, the fact that a company has a working capital ratio of 1.0-2.0 (positive working capital) does not necessarily infer that the company is absolutely doing well. For instance, a high ratio might be an indication that the company engages in less investment or there is excess inventory in a company.
References for Working Capital
Academic Research on Working capital
Does working capital management affect profitability of Belgian firms?, Deloof, M. (2003). Journal of business finance & Accounting, 30(3‐4), 573-588.
Effects of working capital management on SME profitability, Juan García-Teruel, P., & Martinez-Solano, P. (2007). International Journal of managerial finance, 3(2), 164-177.
Working capital management and profitability–case of Pakistani firms, Raheman, A., & Nasr, M. (2007). International review of business research papers, 3(1), 279-300.
Working capital and fixed investment: new evidence on financing constraints, Fazzari, S. M., & Petersen, B. C. (1993). The RAND Journal of Economics, 328-342.
Relationship between working capital management and profitability of listed companies in the Athens stock exchange, Lazaridis, I., & Tryfonidis, D. (2006).
The relationship between working capital management and profitability: Evidence from the United States, Gill, A., Biger, N., & Mathur, N. (2010). Business and economics journal, 10(1), 1-9.
The Influence of working capital management components on corporate profitability, Mathuva, D. (2015).
Trends in working capital management and its impact on firms’ performance: an analysis of Mauritian small manufacturing firms, Padachi, K. (2006). International Review of business research papers, 2(2), 45-58.
Impact of aggressive working capital management policy on firms’ profitability, Nazir, M. S., & Afza, T. (2009). IUP Journal of Applied Finance, 15(8), 19.
An analysis of working capital management results across industries, Filbeck, G., & Krueger, T. M. (2005). American Journal of Business, 20(2), 11-20.