Working Capital
Working capital, also known as net working capital or NWC, is a financial metric and it represents operating liquidity existing for a business. Along with fixed assets like plant and equipment, working capital is considered to be a part of operating capital. It is computed as current assets minus current liabilities. If current assets are less as compared to current liabilities, the entity has a working capital deficiency. Working capital deficiency is also called a working capital deficit.
Working Capital = Current Assets - Current Liabilities
A company can be having assets and profitability but may be short of liquidity if its assets are not in a position to be readily converted into cash. Positive working capital is needed to ensure that a firm is able to carry on its operations and that it has adequate funds to satisfy both - the maturing short-term debt as well as upcoming operational expenses. Management of working capital involves managing inventories, managing accounts receivable & payable and cash.
Calculation
Working Capital Ratio [Current ratio] = Current Assets/Current Liabilities
This ration indicates whether a firm has adequate short-term assets for covering its immediate liabilities. Anything below 1 reflects a negative W/C (working capital). While anything above 2 indicates that the company is not investing its excess assets. There exists a general belief that a ratio between 1.2 and 2.0 is sufficient.
Current assets and current liabilities comprise of three accounts that are of special importance. These accounts indicate the areas of the business where managers have a direct impact:
- accounts receivable (current asset)
- inventory (current assets), and
- accounts payable (current liability)
The current portion of debt (that is payable within 12 months) is critical, since it represents a short-term claim on current assets and is often secured by long term assets. General types of short-term debt are lines of credit and bank loans.
An increase in working capital points out that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for instance has paid off short-term creditors.
Management of working capital
The management makes use of a combination of policies and techniques for the purpose of management of working capital. These policies intend to manage the current assets (generally cash and cash equivalents, inventories and debtors) and the short term financing, such that cash flows and returns are acceptable.
- Cash management. Identify the cash balance that allows the business to meet day to day expenses. It reduces cash holding costs.
- Inventory management. Identify the level of inventory that allows for uninterrupted production but lessens the investment in raw materials - and also minimizes reordering costs – leading to increased cash flow.
- Debtor's management. Identify the suitable credit policy, i.e. credit terms by which the customers will get attracted, such that any impact on the cash flows and the cash conversion cycle shall be offset by increased revenue and hence Return on Capital (or vice versa)
- Short term financing. Identify the suitable source of financing, on the basis of the cash conversion cycle: the inventory is preferably financed by credit granted by the supplier; however, it may be necessary to make use of a bank loan (or overdraft).
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