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What is Working Capital and How it is Calculated?

Working capital, which is also called “Net working capital” is the difference between a company’s (current) liabilities and its (current) assets. Understanding what working capital is can help businesses to understand its financial health in addition to its operational efficiency and liquidity.


  1. What is Working Capital?
  2. How to Calculate Working Capital
  3. What is Net Working Capital?
  4. A Misleading Net Working Capital
  5. Altering the Net Working Capital

working capital
Working capital is the difference between a company’s (current) liabilities and its (current) assets. Understanding what it is can help businesses to understand its financial health in addition to its operational efficiency and liquidity. (© pexels.com)

What is Working Capital?

Let’s imagine that you have invested a lot of working capital into your business. You will have much more potential to grow. However, if your business’s assets don’t exceed its liabilities, you could have difficulty paying back your creditors or you might have difficulty expanding.

If a business wants to bring out a new product or expand into new markets, they might need some investment into their working capital. This will reduce cash flow; however, the amount of cash will fall if it is not collected quick enough.

Any business that inefficiently uses their working capital can make things run more smoothly by putting pressure on their customers and their suppliers to help.

How to Calculate Working Capital

If you would like to calculate your business’s working capital, you compare its current liabilities to its current assets.

Current assets are:

  • cash
  • inventory
  • accounts receivable and anything else that can be sold or liquidated in 12 months or less.

Current liabilities are:

  • wages
  • long-term debt
  • taxables payable
  • accounts payable

The formula that’s traditionally used to work out working capital is:

Current assets – Current liabilities = Working capital

What is Net Working Capital?

Net operating working capital is a real measure of a business’s liquidity. This amount refers to the difference there is between the operating current liabilities and operating current capital. In some cases, these amounts are the same and they come from accounts receivable and company cash, plus the inventory and minus any accrued expenses. The net working capital is used to measure a business’s short-term liquidity. What’s more, is it can be used to help give an impression of the company’s ability to utilise their assets efficiently.

If you wish to calculate the net working capital, you use this formula:

Cash and any cash equivalents + marketable investments + inventory + trade accounts receivable – trade accounts payable = your net working capital.

If the net working capital is very positive, it indicates that short-term funds are available. They come from current assets and there’s more than enough to pay for any current liabilities. If the net working capital is very negative, the business might not be able to pay any current liabilities. In cases such as this, bankruptcy could occur. When net working capital is tracked, it can show a decline in improvement over time.

Net working capital can be used to determine whether a business can grow quickly. If there are a lot of cash reserves, the business might be able to scale-up quickly. However, if there is little cash it means the business is a lot less likely to grow. This can be determined if the accounts receivable are shorter than accounts payable. In other words, a business needs to collect payment before it can pay its suppliers.

A Misleading Net Working Capital

Misleading

A businesses net working capital can be quite misleading. This is because it can have a lot of credit which can pay for any shortfalls. This means there is very little risk of bankruptcy. The credit is used when an obligation has to be paid. The business can also use their working capital against the credit that they have left. If there is not much credit left, there could be a liquidity issue.

An anomaly

If the net working capital is measured using one date it will not account for its general trend. A large and one-time-only account that is payable night not have been paid as yet. This means a smaller figure is created.

Liquidity

Current assets are not always very liquid. This means that they might not be available for paying short-term liabilities. In addition to this, some accounts receivable night not be collected in the short-term. This is the case if the credit terms are very long.

Altering the Net Working Capital

The net working capital can be altered in the following ways:

  • Asking customers to make a payment much more quickly.
  • Actively collecting any outstanding debts
  • Using just-in-time inventory purchases
  • Sending unused inventory back to suppliers
  • Extending the time period between receiving the goods and when payment is made

Conclusion

What is working capital? It’s the difference between a company’s (current) liabilities and its (current) assets. Understanding what working capital is can help businesses to understand its financial health in addition to its operational efficiency and liquidity.

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