It is a measure of a company’s liquidity position and its financial strength; working capital reflects the ability of a company to settle its short term debts which are usually for a year such as payment to the suppliers for the goods purchased on credit, bank overdrafts payments and payment of expenses accrued over the year.
Liquidation is a term used to define the winding up of the business; a procedure to shut down the business and terminate its activities by distributing all the assets of the company to the creditors who have a claim from the company, settling all the debts, and removing the company’s existence.
Working capital is an essential element for businesses as it helps them to run their operations smoothly and efficiently.
It is one of the many financial metrics used by investors to judge the efficiency of the company and to analyze its future profitability.
A positive working capital indicates healthy financial management of the company and it encourages creditors to offer their products and services on credit to the company because they have the confidence that they will receive their payments timely.
However a negative working capital in the balance sheet of the company is detrimental to the company’s opportunity to receive loans, it levies an unfavorable impression on the stakeholders and depicts financial difficulties.
For calculation of the working capital company’s current assets are compared with its current liabilities.
Current assets include assets that can be liquidated, turned in cash within a year such as trade receivables, bank, and inventories whereas current liabilities are the debts to be paid within a year.
Working Capital = Current Assets – Current Liabilities
Extract from the Balance Sheet
|Current Assets||Amount($)||Current Liabilities||Amount($)|
|Trade Receivables||220,000||Accrued Expenses||150,000|
|Short term investments||140,000||Current portion of long term debt||35,000|
With the information mentioned above the working capital of Company ABC is:
$680,000 – $565,000 = $115,000
Company ABC has a positive working capital which normally specifies that it will immediately pay off its debts and will also be able to expand its activities and invest in profitable ventures.
However, a negative working capital often leads to the insolvency of the business which means that the business is no longer able to pay its obligation when they become due.
The business can then convert its negative working capital into positive by raising long-term loans in the form of bonds or debentures or through raising shares.
However in the event of not being able to raise funds to meet the short-term debts the business may be forced into liquidation which means the closing of the entity and going bankrupt.
A liquidator is appointed to dissolve the company’s operations and to convert all the assets into cash by selling them so that the claims of the stakeholders can be discharged according to their priority; the topmost claim is of the creditors who have collateral security attached to their loans such as a mortgage or a pledge.
The next to receive their claims are the unsecured creditors such as debenture holders, bondholders, suppliers, or employees.
And finally, if there are any remaining assets these are given to the shareholders, in this case, preferred stockholders are given priority over the ordinary stockholders.