What is Working Capital?
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.
How is Working Capital Used?
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.