In business, working capital is money available to run daily operations; it is considered life blood for a company and calculated by excluding current liabilities from current assets. If current assets of a company do not exceed its current liabilities then it may get into trouble while paying its short term liabilities like short term loan etc. It is used to measure the short-term liquidity of a company like other liquidity ratios and calculated as under:
Working Capital = Current Assets – Current Liabilities
Suppose, a company XY is a fast food chain with its six branches across a city, it has $4,500 of accounts receivable, $1,000 of cash in hand, and creditors of $2,100. The working capital of the company will be:
Working Capital = Current Assets (Accounts receivable + Cash in hand) – Current Liabilities (Creditors) = $3,400
The amount of $3,400 means that the company is in good liquidity position because after paying short-term liabilities of $2,100 it still has $3,400 to run daily operations.
Factors to consider while calculating working capital
To analysis working capital, we may not simply exclude current liabilities from current assets, sometimes we may need to consider following factors while calculation:
The nature of company’s sale and it’s when customers pay. If a company has an online store and accept online payments then there would no need for high working capital because of no customer receivable time period.
The facility of credit line from banks. If company avails credit line facility and no borrowing then again there would be a need for the little amount of working capital.
How quickly assets can convert to cash. If a company has the majority of cash and cash equivalent current assets, a smaller amount of working capital will be sufficient whereas if there are significant assets which cannot convert to cash easily then a greater amount of working capital is required.
A higher working capital may not be the good sign sometime because it may increase due to excess amount of inventory which means that management is not utilizing sufficient cash efficiently and effectively.