The difference between a company’s current assets and current liabilities is called working capital. You can say that the working capital is the number of liquid assets which are using by the company to conduct their business.
Working capital should be efficiently used in order to achieve long term growth and profitability.
It is one of the major tool for management and creditors to evaluate the current position of the business.
Management uses working capital analysis to assess liquid assets in a more meaningful way i.e. the proper management of cash flows and inventories while the vendors and creditors are using working capital calculations to access the company’s ability to pay their debt in time or not.
Formula for Working Capital
The formula for working capital is
Working capital = Current Assets – Current Liabilities
So, if you want to calculate the working capital for your business, first you have to understand all the components involved in calculation of working capital.
Components of Working Capital:
Current assets are the one side of working capital formula. They can be defined as, type of assets which are easily convertible to cash in less than one year are called current assets.
Current assets are mainly utilized to meet the requirements of daily operations of the business.
Working capital management is mainly controlled by managing current assets of the business.
Current assets are composed of cash and bank balances, trade receivables, short term advances, prepaid expenses, inventory and short-term investments. Let us understand some of components in the below section
Cash and Cash Equivalents
You will see the term cash under the current assets in the balance sheet. This is the most liquid of funds and very essential for every business to maintain the smooth operations of their business.
Sufficient amount of cash should be present with the company to fill any unexpected gaps in the production and sales cycle.
The account receivable is the amount of money receivable from clients arises due to credit sales by the company in the normal course of business. You will find account receivables on the company’s balance sheet under the current assets.
The important point is that they are classified as assets but in real, they are not available for usage until realized in more liquid form.
This is an important component of working capital management and should be efficiently manage to improves the financial health of the company’s operations.
Stock / Inventory are the goods, which purchased by company with a view to resell in the market and earn profits. The turnover of inventory determines how the successful the business is.
Accounts payable are the obligation upon company to pay off its debt due from its creditors, and suppliers.
Accounts payable comes under the head of current liabilities and one of the major components of working capital management. Accounts payable can be managing through negotiations with creditors to extend the payment period.
Like the management of account receivable and inventory, accounts payable management is also a key component in managing working capital.
If the company fails to get a longer period for its short-term debts while its own collection period is slightly longer as compared, then there is a chance that the shortage of cash may arise. Which may lead to financial crises.
So companies should have managed their accounts payable in a way that average days of payable outstanding should be less than the average collection period of the company. So that company will continue its operations without any problem.