Things to Know about Working Capital
Working capital is the funds available to a company for its daily operations. It is viewed as a measure of the liquidity, overall health, and efficiency of the company and comprises of accounts payable, accounts receivable, inventory, cash, short-term accounts, and a portion of debt due within one year of the company. Therefore, it is a reliable indicator of the company’s activities and progress. It reflects the revenue collection, debt management, inventory management, and payments to suppliers by the company. Below is a discussion of working capital and different ways to manage it.
Working Capital Formula
The working capital of a company is calculated by subtracting the total value of its current liabilities from the total value of its current assets. Positive working capital means that the company would be able to pay off its short-term liabilities immediately.
This is the reason why analysts pay special attention to the decline in working capital. In case of a decrease in working capital, they say that the company is overleveraged, is paying bills too quickly, is collecting receivables too slowly, or is struggling to maintain or grow sales. In cases where it increases, they suggest the opposite.
Other ways to analyze the company’s working capital include the receivables ratio, the inventory-turnover ratio, calculating days payable, the quick ratio, and the current ratio.
Smart Working Capital Management
One of the important uses of working capital is its relation to inventory. The longer inventory stays on the shelves of a warehouse, the further the working capital is also stuck.
If businesses are not properly managed, they can consume excessive amounts of money for expansion. This happens when the company uses its cash to pay for all its needs instead of seeking financial help to make these payments. Therefore, the working capital deficit could cause businesses to fail although they may be running at a profit. The smartest companies invest wisely to avoid these situations.
Besides, analysts underscore that the timing and level of a company’s cash flow are crucial for its ability to pay off its liabilities. The working capital, as dictated by the definition, is not as simple if it were to be managed by using its assets to pay off the liabilities. This is not a realistic possibility. There are other requirements outside of this consideration which needs to be prioritized such as operations and payroll obligations.
Overall, working capital is a true indicator of the state of a company’s finances. It has to be managed smartly if the company has to grow in an expected manner.