Definition:

Working capital is a term commonly used for the capital required for day to day working in a business entity, for purchasing raw materials to be used in production, for meeting daily expenditures like salaries, wages, advertising, etc.

It is also popularly called circulating capital due to the nature of it which keeps changing.

Working capital depicts those assets which change with relative speed from one form to another like starting from cash, purchasing raw materials, incurring direct expenses, sales of products, and receipt of cash i.e. realization at the end. This is called the circulating process.

Working capital can be classified into two ways:

Concept-Based working capital:

Time-Based working capital:

  • Permanent or Fixed working capital
  • Temporary or variable working capital

Here is the explanation,

  1. Gross working capital: It refers to the firm’s investment in total current or circulating assets.
  2. Networking capital: It is a commonly accepted definition. It is the excess of current assets over current liabilities. It is that portion of a firm’s current assets which is financed by long-term funds
  3. Permanent working capital: It to that minimum amount of investment in all current assets which is required at all times to carry out day to day operations of the business entity.
  4. Temporary working capital: it represents additional current assets required at different times during the operating year. For example: when receivables increase during peak sales, it is to be financed. On the other hand, a decrease in receivables occurring during off-season sales.
  5. Negative working capital: This situation is a crisis for the business entity. This situation occurs when the current liabilities exceed the current assets.

Formula:

Calculation of working capital is done using the simple formula as:

Working capital = Current Assets – Current Liabilities

Key components of Working Capital

Current Assets:

Current assets have a span of period lesser than the accounting period which is generally 12 months.

Current assets are engaged in the current operation of a business and normally used for short term operations of the firm. Examples of current assets include:

  • Cash and cash equivalents
  • Temporary investments
  • Accounts receivables
  • Inventory
  • Prepaid Expenses

Current Liabilities:

Current Liability is an obligation created towards creditors or suppliers from whom it has purchased raw materials on credit.

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This liability is also known as accounts payable and shown in the balance sheet until the payment has been made to the creditors.

The claims or obligations which are normally expected to mature for payment within an accounting cycle are known as current liabilities. Examples of Current Liabilities include:

  • Accounts Payable
  • Wages Payable
  • Loan principal amounts due within one year.
  • Customer deposits
  • Deferred revenues

Operating Cycle:

A company’s operating cycle is the average amount of time it takes for the company’s cash to be put into the business operations and then make its way back into the company’s cash account. 

The operating cycle resembles the circulation of working capital. Having operating cycle at least the industrial standard is required to prosper. Lower the operating cycle, the better the cash flows and the financial growth of the company

Example and Calculation:

Let us take an example of Balance sheet and calculate working capital:

The balance sheet of Sinra Inc
Cash 30,000 Accounts Payable 20,000
Marketable securities 20,000 Notes Payable 12000
Accounts Receivable 15000    
Merchandise Inventory 12000    
Total Current Assets 77,000 Total Current Liabilities 32,000

Using the working capital formula and the information above from the table above, we can calculate Sinra Inc’s working capital as:

Working capital = Current Assets – Current Liabilities = 77000 -32000 = $45000

Analysis:

This is a positive working capital. Positive working indicates the company can immediately pay off its current liabilities. Analysts always prefer positive working capital. They are sensitive to a decrease in working capital.

The decrease in working capital may be due to overleverage, a company struggling to grow sales, delay in the collection of accounts receivables.

While in general, having negative working capital is bad for the company but it has been seen in the industry that having negative working capital does not matter as long as there is a quick turnaround on buying to sales.

It also depends on the business model of the entity where negative working capital may be preferred to maximize return on current assets.

For example, Daily stores like Walmart prefer negative working capital. Their business model is based on a quick turnaround of all the products.

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This means the operating cycle is very low in Walmart where the product is bought and sold quickly and payment received is paid to the suppliers as quickly as possible.

This results in a constant flow of working capital and increases the return on current assets and returns on assets on the whole.

Working Capital Management Ratios:

In this segment we will discuss the various ratios related to working capital along with calculation with respect to example as discussed above:

a) Current Ratio: Also called the working capital ratio, it measures a firm’s ability to pay off its current liabilities with current assets. The current ratio is very important to creditors because it shows the liquidity of the company.

Current Ratio = Current Assets/Current Liabilities = 77000/32000 = 2.40

Current Ratio measures current assets as a percentage of current liabilities. It makes sense that a higher ratio is preferable. A current ratio of 1 is considered not so good but not that risky as well.

However, it is not also a middle ground. A ratio above 1 indicates that the company can pay all its current liabilities and be still left with current assets or positive working capital.

b) Acid Test Ratio: Also known as the quick ratio, it measures firm’s ability to match current liabilities in case asset is liquidated to cash in short period of time, generally being less than 3 months, without the loss of value.

It uses liquid assets instead of current assets. Current assets excluding inventory and prepaid expenses equal liquid assets.

Acid test ratio = Liquid Assets/ Current Liabilities = 50,000/32000 = 1.5625

The ratio greater or equal to 1 is considered good for acid test ratio.

c) Cash position ratio: Also known as the absolute liquid ratio, includes cash in hand and that in the bank and the temporary investments including marketable securities. This ratio must ideally be 50 percent.

Cash Position ratio = Cash and cash equivalent/Current Liabilities = 50,000/32000 = 1.5625

In this case, the cash position is very good as it is thrice of the industrial standard of 50%.

Importance of adequate working capital:

  1. Solvency of the business: Adequate working capital helps in maintaining the solvency of the business by providing cash flows to service the flow of production. The circulation of capital is maintained by adequate working capital.
  2. Cash Discounts from suppliers: There are various credit policies by suppliers where if the buyers pay within the credit terms, they are provided cash discounts on the payment. Adequate working capital also enables a concern to avail cash discounts on the purchases and hence it reduces costs.
  3. Reputation: Sufficient working capital enables a business entity to make prompt payments and hence helps in creating and maintaining goodwill in the business community.
  4. Access to Easy loans: An entity having adequate working capital, high solvency, and good credit standing do have a higher advantage and standing to get loans on easy terms and conditions. The interest rates are also low due to adequate working capital, which inserts low risk to banks and financial institutions.
  5. The regular supply of raw materials: Adequate working capital ensures a regular supply of raw materials, which in continuity ensures a flow of production.
  6. Meeting day-to-day commitments like salaries, wages, monthly rent, etc: A company which has ample working capital can make regular payment of salaries, wages and other day-to-day commitments which raises the working environment and morale of its employees, increases their efficiency, reduces wastages and costs and enhances production and profits.
  7. The exploitation of favorable market conditions: Only concerns with adequate working capital can exploit favorable market conditions such as purchasing in bulk when the prices are lower and by holding its inventories for higher prices. For example, an entity based on non-perishable agricultural commodities can buy the commodity in bulk and hold it and sell it after the handsome price is offered.
  8. Meeting Rainy Day: Adequate working capital enables a concern to face a business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital. Generally, small organizations face this situation of rainy days when the large orders are accepted without cash in hand or due to irregular economic growth in the industry.
  9. Easy and appropriate return on Investments: Every Investor wants a quick and regular return on his investments. Adequate working capital helps an entity to pay quick and regular dividends to its investors as there may not be much pressure to plow back profits. The gain made confides to the investors creating a favorable market that is conducive for business growth in the future.