Working capital is the amount of liquid assets a company has, minus any liabilities (money owed). It allows companies to finance and grow their businesses without the need for more expensive outside sources of funding.
The primary use of working capital is to fund ongoing operations. For example, if a business wants to bring a new product to market, it will need cash on hand to pay for the design, development, and distribution of the product until they can sell enough units to recover their costs.
The importance of working capital is usually emphasised in larger companies. These businesses have to finance a large number of staff and supplies, so they are more affected by changes in working capital. However, even small businesses need some working capital. A company with high working capital is considered to be in a better position than one that does not have enough working capital.
Working Capital Formula
The working capital calculation is:
Working Capital = Current Assets – Current Liabilities
Sources of Working Capital
Working capital can be acquired from numerous sources:
In the equation above, current assets are cash and its equivalents. Total cash is the difference between the sum of all bank accounts and all cash on hand. The second part of working capital is current liabilities. This is represented in the equation by debt owed to other people and money invested in stocks or bonds.
There are three ways that companies accumulate their current assets, including through previous financial transactions, retained earnings, and sales. The retention of earnings is the primary source of current assets for a large majority of companies. This is achieved because the company makes a profit. The profit remains with the company and can be used to invest in growth or to pay off any outstanding debts.
Working capital sources can be long-term, short-term, and spontaneous. Share capital, retained profits, debentures, long-term loans, and provision for depreciation are usually considered long-term working capital sources. The sources of short-term working capital include tax provisions, public deposits, cash credits, and others. Whereas, spontaneous working capital includes notes payable and bills payable.
What is the Working Capital Cycle?
The working capital cycle is the time involved for a company to get from one point (where assets have been created, liabilities paid off, and profits distributed) to another. In fact, the working capital cycle starts when the company has positive working capital and ends when the company has negative working capital. Therefore, a company is considered to free up its blocked cash swiftly if it has a shorter working capital cycle. All companies, in fact, try to reduce the working capital cycle to improve liquidity in the short term.
Examples of Working Capital
Calculating Working Capital Example 1
If a company has $16,990 USD in its bank account, it also owes $9648 USD in debt to suppliers. The company and its suppliers have agreed to pay all these debts by 21st December. Similarly, the company has $4331 USD in cash on hand and a stock of $9648 USD. The company does not have any long-term debts (debts for the next 12 months or more).
According to the above situation, the working capital of this company is as follows:
Working capital = $16,990 USD – $9648 USD = $9648 USD.
The working capital of this company is $9648 USD.
Calculating Working Capital Example 2
If a company has $23,926 USD in its bank account and owes $9648 USD to suppliers. The company also has a current account of $33,077 USD. Assuming the company is owed money by suppliers during the year.
According to the above situation, the working capital of this company is as follows:
Working capital = $23,926 USD – $9648 USD = $16,990 USD.
The working capital of this company is $16,990 USD.
Calculating Working Capital Example 3
If a company has $33,077 USD in its bank account and owes $16,990 USD to suppliers. The company also has a current account of $23,926 USD. Assume the same situation happens in future months.
According to the above situation, the working capital of this company is as follows:
Working capital = $33,077 USD – $16,990 USD = $16,990 USD.
The working capital of this company is $16,990 USD.
Advantages of Working Capital
1. Solvency of business
When a business has more working capital than its current liabilities, it is known as the "solvency" of the business. This is an excellent situation for any company and can be used for many different purposes.
2. Easy loans
When a company has cash on hand, it can easily get loans from banks. Even if the company's credit rate is not good, it can still get a loan because of its cash reserve. Loans from banks with good interest rates are important for small and medium-sized businesses.
3. Regular supply of raw materials
If a company has working capital, it can easily get raw materials from suppliers. This is a good situation for any company because, if everything goes well, it is able to bring in regular supplies of raw materials and, thereby, reduce its production costs.
4. The exploitation of favourable market conditions
A company that has high working capital means that the business is well-solvent. When a business has positive working capital, it can easily exploit favorable market conditions and make a profit. This can be good for the company's profitability.
5. Ability to face a crisis
A company with good working capital can be able to face a crisis and make changes in the business. When a company has a lot of cash on hand, it will not have trouble doing anything, and crisis are easily overcome.
Check out more in our blog Working Capital in Retail: The firework you need for the Big Bang deals this Diwali.
Frequently Asked Questions
1. How do you calculate working capital?
The formula for working capital is as follows:
Working Capital = Current Assets – Current Liabilities
In the above formula, current assets are the cash and its equivalents, current liabilities are represented by all debts owed to other people and money invested in stocks or bonds. And the working capital refers to the total amount of liquid assets a company has on hand (the current assets).
2. What is another name for working capital?
Working capital is one way to measure a company's liquidity position. It is also called venture capital, equity capital, fixed capital, and working asset.
3. Is salary a working capital?
No. Salary cannot be calculated as the working capital of a business. Once paid, salaries cannot also be included in current liabilities.
