This refers to the amount of cash a business can safely spend. It’s commonly defined as current assets minus current liabilities. Usually, working capital is calculated based on cash, assets that can quickly be converted to cash (such as invoices from debtors), and expenses that will be due within a year. Working Capital = Current Assets - Current Liabilities.
Working capital is the difference between a company’s current assets, such as cash, accounts receivable, and inventories of raw materials or unfinished goods, and its current liabilities, such as accounts payable.
The formula a business can use for working capital is Current Assets - Current Liabilities = Working Capital
Working capital is a necessity in order for a business to remain solvent, or having assets in excess of its liabilities.
What Is Working Capital?
Working capital, also known as networking capital (NWC), is the difference between a company’s current assets, such as cash, accounts receivable, and inventories of raw materials or unfinished goods, and its current liabilities, such as accounts payable. This is a measurement of a company’s liquidity and refers to the difference between operating current assets and operating current liabilities.
Working capital also gives a snapshot of the company’s operational efficiency and its short-term financial health. If current assets do not exceed its current liabilities, then it could be difficult for a business to grow or pay back creditors.
Formula For Working Capital
To calculate a company’s working capital, compare its current assets to its current liabilities. A company’s current assets listed on a balance sheet could include cash, inventory, accounts receivable, and assets expected to be liquidated, turned into capital, in less than one year. Now for current liabilities that could include taxes payable, accounts payable, wages, and long-term debt. A helpful way of remembering is it typically looked at as though current assets are available within 12 months and current liabilities are due within 12 months.
Why Is Working Capital Important?
Working capital is a necessity in order for a business to remain solvent, or having assets in excess of its liabilities. A business cannot simply rely on accounting profits in order for bills to be paid. These debts need to be paid with capital readily on hand.
If a company were to have accumulated a sum of money, say a total of $1 million, they would not want to invest this money all at once. In doing so, they could potentially find out their current assets are insufficient in being able to pay for their current liabilities.
Reasons A Business Might Require Working Capital
Seasonal Sales: Like the weather, so too are there seasonal differences in cash flow. A business could require additional capital to gear up for a busier season or to ensure that operations are consistent when less money is coming in.
Waiting on Payment: There is almost a guarantee that all businesses will have a time when additional capital is needed to pay employees and obligations to suppliers while waiting for payments for customers.
Purchasing Options: An abundance of working capital could help improve the business. An example would be being able to purchase in bulk. Many suppliers offer a discount when purchasing in a bulk fashion.
Increased Workload: Having additional working capital can be used for such things as project-related expenses and temporary employees.
Every business wants to remain solvent and in order to do so working capital is needed. As stated previously, a business cannot simply rely on accounting profits in order for bills to be paid. Most businesses want growth and having liabilities exceed assets is not how to grow. Ensure a company has adequate working capital and business will flow a lot smoother.