What is Working Capital?
Working capital is a measurement of an entity’s current assets, after subtracting its liabilities. Sometimes referred to as operating capital, it is a valuation of the amount of liquidity a business or organization has for the running and building of the business. Generally speaking, companies with higher amounts of working capital are better positioned for success. They have the liquid assets needed to expand their business operations as desired.
Sometimes, a company will have a large amount of assets, but have very little with which to build the business and improve processes. Even a profitable company may have this problem. This can occur when a company has assets that are not easy to convert into cash.
This measurement can be expressed as a positive or negative number. When a company has more debts than current assets, it has negative working capital. When current assets outweigh debts, it becomes positive.
Changes in working capital will impact a business’ cash flow. When it increases, the effect on cash flow is negative. This is often caused by the liquidation of inventory or the drawing of money from accounts that are due to be paid by the business. On the other hand, a decrease translates into less money to settle short-term debts.
Working capital is among the many important things that contribute to the success of a business. Without it, a business may cease to function properly or at all. Not only does a lack of capital render a company unable to build and grow, but it may also leave a company with too little cash to pay its short-term obligations. Simply put, a company with a very low amount of working capital may be at risk of running out of money.
When a company has too little working capital, it can face financial difficulties and may even be forced toward bankruptcy. This is true of both very small companies and billion-dollar organizations. A company with this problem may pay creditors late or even skip payments. It may borrow money in an attempt to remain afloat. If late payments have affected the company’s credit rating, it may have difficulty obtaining a loan at an affordable interest rate.
In some types of businesses, it isn’t as much of a problem to have a lower amount of working capital. Companies that are operated on as cash basis, have fast inventory turnovers, and can generate cash quickly don’t necessarily need as much.
@anon108897: An increase in working capital has a negative effect on cash flow (bought inventory and raised accounts receivables), and conversely, an increase in cash (sold inventory and collected accounts receivable) has a negative impact on working capital.
I have generally seen the formula written as:
WC = (Current Assets - Cash) - (Current Liabilities - ST Debt)
Cash is one component of working capital. How can an increase in cash have a negative impact on working capital?
@ PelesTears- The article started to get into working capital management towards the end. The amount of working capital really depends on the type of business. Businesses usually try to have as little cash on hand as possible, yet still remain liquid. Cash does not earn money as it sits there; it actually decreases in value due to inflation.
Businesses manage working capital in a similar fashion. A business wants to have the maximum amount of money invested, but needs to be able to have adequate amounts on hand to cover immediate liabilities.
Businesses with high rates of inventory turnover like Wal-Mart or Target need less working capital than businesses with low inventory turnover like Caterpillar or Ralph Lauren. Additionally, businesses that only have seasonal manufacturing processes or are in cyclical markets (Fishery, auto manufacturer, etc.) may need higher levels of working capital than non-cyclical companies may.
How does a business determine the amount of working capital it needs?
Enumerate and briefly explain 5 methods of financial working capital. Thank you.
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