Last updated August 16, 2023
What does it mean?
Working capital refers to the difference between a company’s current assets and its current liabilities. It represents the funds available to a company for its day-to-day operations and is a measure of its short-term financial health and liquidity.
How to calculate working capital?
In mathematical terms, the concept is calculated with the following formula:
Working capital = Current Assets - Current Liabilities
- Current assets are the assets that are expected to be converted into cash or used up within a year or the normal operation cycle of the business. Examples include cash, accounts receivable (money owed by customers), inventory (goods for sale), and short-term investments.
- Current liabilities, on the other hand, are obligations that the company is expected to settle within a year or the normal operating cycle. Examples include accounts payable (money owed to suppliers), short-term loans, and other short-term debts.
What are the main states of working capital?
- Positive working capital: This means that a company’s current assets exceed its current liabilities. It indicates that the company has sufficient resources to cover its short-term obligations.
- Negative working capital: If a company’s current liabilities exceed its current assets, it has negative working capital. This situation can indicate financial stress, potential liquidity issues, and difficulty meeting short-term obligations.
Why is working capital important?
- Operational continuity: Positive working capital ensures that a company has enough resources to cover its short-term obligations and continue its day-to-day operations.
- Liquidity: It indicates a company’s ability to meet its short-term financial obligations and manage unexpected expenses without resorting to emergency measures.
- Growth: Adequate working capital can support business expansion, allowing a company to invest in new projects, purchase additional inventory, and hire more staff.
- Creditworthiness: Lenders and suppliers often evaluate a company’s working capital to assess its financial stability and creditworthiness.