The working capital of an entity is defined as the difference between current assets and current liabilities. It is an interpretation of how liquid the company is in the short term.
A positive working capital indicates that the company has enough money to pay off its debts and is financially stable whereas a negative working capital indicates an imminent bankruptcy.
Current assets are those assets that are expected to be sold, consumed or converted to cash within the current fiscal year through the normal course of business.
Current liabilities are those liabilities or debts that are due or are expected to be settled within the current fiscal year through the normal course of business.
Importance of working capital:
Working capital is an essential used by financial institutions, suppliers, and investors to judge the efficiency of a company.
It is a representation of how the company manages its daily operations which includes revenue collection, inventory management, payment to creditors, etc.
A company is considered healthy and liquid when the current assets are sufficient to pay off the current debt. Managing your working capital is crucial for getting better deals with your suppliers or banks for loans.
Accounting for working capital:
The two components of working capital i.e. current assets and current liabilities are reported on the balance sheet of the company.
Assets like accounts receivable, cash and bank, inventory, interest receivable are reported under the heading current assets in the Assets section of the balance sheet.
Short-term liabilities like accounts payable, bank overdraft, interest or dividend payable are reported under the heading current liabilities in the Equity and Liabilities section.
Working capital is also used as a financial analysis ratio. The current ratio and quick ratio is a reflection of the company’s liquidity.
A good current ratio would be between 1.5 and 2.
A good quick ratio would be greater than 1.
Calculation of working capital:
The formula to calculate working capital is:
Working capital = Current Assets – Current Liabilities
Let’s illustrate this through an example. Following is the balance sheet of Zellind limited:
Required: Calculate the working capital.
Step#1: Calculate the value of current assets.
Current assets = Cash & bank + accounts receivable + inventory
Current assets = 500 + 4500 + 3000 = $8,000
Step#2: Calculate the value of current liabilities.
Current liabilities = Bank overdraft + Accounts payable + Accruals
Current liabilities = 1600 + 2200 + 2400 = $6,200
Step#3: Apply the values to the formula of working capital.
Working capital = Current assets – Current liabilities
Working capital = $8,000 – $6,200 = $1,800
Zellind Limited has a positive working capital of $1,800 meaning that it is liquid enough to pay off its current debts.
Since Zellind Limited can pay back their creditors within a year, they can even avail cash discounts on early payments as well as get better deals with banks due to a better credit score.
The major advantage of positive working capital is it helps reduce costs and increase profits i.e. the prime objective of a profit-maximizing entity.