What is working capital?
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What is working capital?

  • 2 min read

  • Highlights

  • Working capital = Current assets - Current liabilities

  • Businesses use working capital to meet daily operations

  • It measures the short term financial health of your company

  • Working capital cycle is the time taken to convert net working capital into cash

Definition:

Working capital is the amount of funds available to a company for managing day to day operations. These daily expenses can include office materials, maintenance costs, rent and utilities cost. It can be used to measure the financial capability of a business to pay off short term borrowings and liabilities. Working capital cycle is considered as the time taken to convert short term assets into cash.

How to Calculate Working Capital:

Working capital is calculated as the difference between Current Assets comprising of cash, accounts receivables, marketable securities and inventories; and Current Liabilities comprising accounts payable, short term loans and accrued liabilities.

Working capital can also be evaluated with the help of a financial ratio and current assets divided by current liabilities.

If the resulting number is less than 1.0, it denotes that your current liabilities exceed your current assets resulting in a negative working capital.

And if the number is more than 1.0, it can be a sign of a healthy business. However, a very high number can denote slow moving inventory on hand. Ideal working capital can vary depending on the line of business. Generally, a score between 1.2 and 2.0 is considered healthy.

Importance Of Working Capital


Additional Read: Why Working Capital Finance is Necessary For Small Businesses

To Attract Investors: Working capital is of utmost importance for businesses looking at potential lenders. Investors use this as a means to calculate the risk involved in lending to companies seeking Business Loans, thus negative working capital can render your business a risky investment. Lenders consider businesses with positive working capital as more likely to pay off the debt in time.

For Day to Day Operations: The company’s ability to convert short term assets into cash is calculated with the help of working capital. Positive working capital indicates the firm’s ability to conduct daily operations. However, negative working capital might not always indicate poor financial health, as in cases of businesses with high inventory turnover rates.

To Support Business Expansion Plans: Positive working capital backs up future expansion plans for business owners. When a company desires to grow, it often purchases additional assets to manufacture products or offer services at a quicker pace and on a larger scale. If a company experiences problems in conducting everyday activities, it would be ill suited to meet rising consumer demands as well as technological advancements.

Increase Your Working Capital

How to Increase Working capital:

Companies with insufficient working capital run the risk of encountering financial insolvency, legal issues, liquidation of assets and potential bankruptcy. Thus, it is crucial to have adequate management of working capital, and a working capital loan can help with this.

Additional Read: How Much Working Capital Does Your Business Need?

To improve your working capital situation, focus on receiving cash payments, encourage customers to pay their invoices early, sell long-term assets for cash or to increase sales revenues.

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