Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organisation or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
A company can be endowed with assets and profitability but may fall short of liquidity if its assets cannot be readily converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
Working capital is the difference between current assets and current liabilities. It is not to be confused with trade working capital (the latter excluding cash).
The basic calculation of working capital is based on the entity's gross current assets.
Current assets and current liabilities include four accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:
The current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.
An increase in net working capital indicates that the business has either increased current assets (that it has increased its receivables or other current assets) or has decreased current liabilities--for example has paid off some short-term creditors, or a combination of both.
Working capital is computed as the sum of: Inventories (+) Trade receivables (+) Cash (-) Trade payables. The working capital cycle (WCC), also known as the cash conversion cycle, is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer this cycle, the longer a business is tying up capital in its working capital without earning a return on it. Companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. Under certain conditions, minimizing working capital might adversely affect the company's ability to realize profitability, e.g. when unforeseen hikes in demand exceed inventories, or when a shortfall in cash restricts the company's ability to acquire trade or production inputs.
A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30-day cycle usually needs to be funded through a bank operating line, and the interest on this financing is a carrying cost that reduces the company's profitability. Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow. Sophisticated buyers review closely a target's working capital cycle because it provides them with an idea of the management's effectiveness at managing their balance sheet and generating free cash flows.
As an absolute rule of funders, each of them wants to see a positive working capital. Such situation gives them the possibility to think that your company has more than enough current assets to cover financial obligations. Though, the same can't be said about the negative working capital. A large number of funders believe that businesses can't be sustainable with a negative working capital, which is a wrong way of thinking. In order to run a sustainable business with a negative working capital, it's essential to understand some key components.
1. Approach your suppliers and persuade them to let you purchase the inventory on 1-2 month credit terms, but keep in mind that you must sell the purchased goods, to consumers, for money. 2. Effectively monitor your inventory management, make sure that it's often refilled and with the help of your supplier, back up your warehouse.
Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.
A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets, and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.
By definition, working capital management entails short-term decisions--generally, relating to the next one-year period--which are "reversible". These decisions are therefore not taken on the same basis as capital-investment decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.
Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.