What is working capital?

What is working capital?

Working capital is a financial metric used in accounting to measure business liquidity and ability to meet its short-term obligations. It is the difference between a business’s current assets (such as cash, accounts receivable, and inventory) and its current liabilities (such as accounts payable and short-term debt).

Enough working capital lets businesses maintain their operations, pay their bills on time, and take advantage of new opportunities. A positive working capital balance indicates that a business has enough liquid assets to cover its short-term debts, while a negative balance may signal financial trouble.

By effectively managing working capital, businesses can improve cash flow, rely on external financing less, and strengthen overall financial health.

How to calculate working capital

Calculating working capital is relatively simple and involves subtracting current liabilities from current assets. The working capital formula is as follows:

Working Capital = Current Assets – Current Liabilities

To calculate working capital, gather the necessary financial information from the balance sheet. Current assets typically include cash, accounts receivable, and inventory, while current liabilities include accounts payable, short-term debt, and other obligations due within one year.

Next, subtract the total current liabilities from the total current assets. These are the company’s financial obligations due to be paid within one year. Examples include accounts payable (money owed to suppliers), short-term loans, accrued expenses (expenses incurred but not yet paid), and the current portion of long-term debt.

The resulting figure is the business’s working capital. A positive working capital indicates the business has enough current assets to cover its immediate expenses, while a negative working capital may indicate potential financial difficulties.

What are the factors that affect working capital?

Several factors can influence working capital. Here’s a breakdown of some key factors:

Business model and industry

Different industries have varying operating cycles (the time it takes to convert raw materials into cash). For example, a manufacturing company with a longer production cycle might require more inventory, leading to higher working capital needs compared to a service-based company.

A company’s core business model can also impact working capital. Companies with a just-in-time inventory management system may require less working capital compared to those holding larger safety stocks.

Sales growth

Growing sales typically lead to a rise in both current assets (inventory and receivables) and current liabilities (payables). However, if sales grow faster than a company can collect payments from customers or manage its inventory efficiently, it can lead to a strain on working capital.

Credit policies

Companies offering generous credit terms to customers (like longer payment deadlines) will have higher accounts receivable, impacting working capital. Conversely, stricter credit policies with shorter payment terms can improve working capital by accelerating cash collection.

Inventory management

Efficient inventory management practices that minimise excess stock can significantly reduce working capital requirements. Conversely, holding excessive inventory increases working capital needs and ties up valuable resources.

Seasonality

Businesses with seasonal sales fluctuations might experience temporary increases in working capital needs during peak sales periods to meet higher demand.

Operational issues

Operational inefficiencies, such as slow receivables collection or delayed payments to suppliers, can negatively impact working capital by hindering cash flow.