What is Working Capital: Importance and Types

What is Working Capital: Importance and Types

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Jaya
Jaya Sharma
Assistant Manager - Content
Updated on Dec 20, 2023 23:16 IST

Working capital is a financial metric that represents the operating liquidity that is available to the business, organization, or any entity. The management of the working capital involves managing inventories, accounts payable, accounts receivable and cash.

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In this article, we will be discussing what is working capital, its importance and its types.

Table of Contents

What is working capital?

Working capital or net working capital (NWC) refers to the difference between the current assets and current liabilities of the company. Current assets include accounts receivable, cash, unpaid bills, and inventories of raw materials. In current liabilities, accounts payable, and debts are counted. It is the measure of the liquidity of a company and the short-term financial health of the company. 

When a company has negative working capital, the ratio of the current assets to liabilities is lesser than one. When a company can fund its current operations and invest in future growth, then it is considered to be positive working capital. When the working capital is in excess, it indicates that a business has too much inventory, excess cash and is not capitalizing on low-expense debt opportunities. 

For calculating the working capital, the company’s current liabilities should be subtracted from the current assets of the company. Let us consider an example where the company has $100,000 of current assets and $40,000 of current liabilities. In such a case, the working capital will be: 

Working Capital = Current Assets – Current Liabilities

= $100,000 – $40,000 = $60,000

Importance of Working Capital

It is the measure of the operational efficiency of the company and short-term financial health. When a company has enough Net Working Capital, it indicates that the company has the potential to invest and grow the company. When the current assets of a company do not outgrow the current liabilities, it can either become stagnant or may struggle to repay its creditors. In short, the company can go bankrupt.

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Current Assets

Let us first take a look at the different current assets that are available. Current assets are those benefits that the company receives within the coming 12 months. The following are the current assets available with the company:

  • Inventory: Every unsold good that is stored is considered to be inventory. This includes all the raw materials that are purchased to be manufactured as well as the unsold goods.
  • Accounts receivable: It is the balance of money due to any firm for services and goods used and delivered but are not paid for yet by the customer. These are listed as current assets on the balance sheet. 
  • Cash equivalents: The amount of money that a company has on hand. This includes certain investments and foreign currency having very low investment term periods and low risk.
  • Prepaid expenses: All the value for expenses that are paid in advance and are difficult to liquidate. These have short-term value. 

Current Liabilities

These are the debts that a company owes or may owe within the period of the next 12 months. The following are the different types of current liabilities:

  1. Wages payable: The unpaid accrued salary and wages for employees is known as wages payable. Depending on the timing of the company’s payroll, it may accrue up to a month’s worth of wage. Such current liabilities are short-term in nature. 
  2. Accrued tax payable: This current liability includes all obligations to the government bodies. It may include accruals for tax obligations for filings that are not due for months. These are due within the next 12 months due to which they are short-term in nature.
  3. Accounts payable: These are the unpaid short-term obligation of the company that it owes to the creditors or its suppliers. AP appears on the balance sheet of the company as current liabilities. 
  4. Unearned revenue: It refers to the money received by an individual or a company for the services and products that are yet to be delivered or provided. It is the prepayment for goods and services that the company supplies to the purchased at a later date. Due to these prepayments, seller has a liability that is equal to the revenue earned until the good or service is delivered. 
  5. Dividend payable: Every authorized payment to the shareholder that has been authorized is known as a dividend payable. A company must fulfill obligations on the already authorized dividends but has the authority to decline future dividend payments.  
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Components of Working Capital

here is a more detailed explanation of the four components of working capital:

1. Cash and Cash Equivalents

These are the most liquid assets on a company's balance sheet. Both are easily convertible into cash without any loss of value. This makes them essential for meeting day-to-day operating expenses and paying off short-term debts.

Examples of cash and cash equivalents include:

  • Cash on hand: Physical currency that is readily available for use.
  • Bank deposits: Money held in checking or savings accounts at a bank.
  • Short-term investments: Investments that can be quickly sold for cash, such as money market funds and certificates of deposit (CDs).

A company must have enough cash and cash equivalents on hand to cover its immediate cash needs and to provide a safety net in case of unexpected expenses.

2. Accounts Receivable

Accounts receivable represent amounts that customers owe to a company for goods or services that have been purchased on credit. They are a type of current asset, as they are expected to be converted into cash within one year.

The amount of accounts receivable on a company's balance sheet will depend on its credit terms and the length of its operating cycle. A company with generous credit terms or a long operating cycle will typically have higher accounts receivable.

Accounts receivable can be a valuable source of financing for a company, but they also carry some risk. If customers are unable to pay their bills, the company may have to write off the debt, which will reduce its cash flow and profits.

3. Inventory

It is the stock of goods that a company holds for sale or use in production. It is a type of current asset, as it is expected to be sold or consumed within one year.

The amount of inventory on a company's balance sheet will depend on its industry, production processes, and sales patterns. A manufacturing company, for example, will typically have more inventory than a retail company.

Inventory are valuable assets for a company, as it allows it to meet customer demand quickly and efficiently. However, it is also a risky asset, as it can become obsolete or deteriorate in value if it is not sold quickly enough.

4. Accounts Payable

Accounts payable represent amounts that the company owes to its suppliers for goods as well as services purchased on credit. They are a type of current liability, as they are expected to be paid within one year.

The amount of accounts payable on a company's balance sheet will depend on its credit terms and the length of its operating cycle. A company with favorable credit terms or a short operating cycle will typically have lower accounts payable.

Accounts payable can be a source of financing for a company, as they allow it to delay payments to its suppliers. However, they also carry some risk. If a company is unable to pay its bills, it may damage its relationships with its suppliers and may even face legal action.

Why do Businesses Need Working Capital?

For the business to remain solvent, different types of working capital are required. The amount of capital that a company has depends on the industry. For example, companies with longer production cycles have higher working capital requirements since they do not have quick inventory turnover for generating cash as per the demand. 

The retail industry has short-term funds requirements that can be quickly raised and have lower working capital needs. It is an essential concept of finance and business that refers to financial resources used by the company for funding its day-to-day operations. Companies may negotiate favorable payment terms with suppliers and customers to improve the cash flow and working capital. Here is a detailed explanation of working capital for those who want to learn about this financial concept in depth.

FAQs

How is working capital calculated?

Current liabilities are subtracted from current assets for calculating working capital. A positive working capital reflects that the company has enough resources to meet its short-term obligations, while a negative working capital may suggest liquidity issues.

What is the significance of positive working capital?

Positive working capital represents that a company has more current assets than current liabilities. It implies that the company has sufficient liquidity to meet its short-term obligations, cover operational expenses, and invest in growth opportunities. Positive working capital is crucial for financial stability and sustainability.

What are the consequences of negative working capital?

Negative working capital implies that a company has more current liabilities than current assets. It may indicate cash flow problems, difficulty in meeting short-term obligations, and potential liquidity issues. Negative working capital requires careful management and prompt action to avoid financial distress.

How can businesses optimize their working capital?

Businesses can optimize working capital through various strategies, including efficient inventory management, timely accounts receivable collection, negotiation of favorable payment terms with suppliers, and effective cash flow forecasting. Minimizing unnecessary expenses and optimizing operational efficiency can also contribute to improving working capital.

About the Author
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Jaya Sharma
Assistant Manager - Content

Jaya is a writer with an experience of over 5 years in content creation and marketing. Her writing style is versatile since she likes to write as per the requirement of the domain. She has worked on Technology, Fina... Read Full Bio