Working capital is just what it says – it is the money you have to work with to meet your short-term needs. It is important because it is a measure of a company’s ability to pay off short-term expenses or debts.
But on the other hand, too much working capital means that some assets are not being invested for the long-term, so they are not being put to good use in helping the company grow as much as possible.
The most important positions for effective working capital management are inventory, accounts receivable, and accounts payable. Depending on the industry and business, prepayments received from customers and prepayments paid to suppliers may also play an important role in the company’s cash flow. Excess cash and nonoperational items may be excluded from the calculation for better comparison.
Working capital is the difference between a business’ current assets and current liabilities or debts. Working capital serves as a metric for how efficiently a company is operating and how financially stable it is in the short-term. The working capital ratio, which divides current assets by current liabilities, indicates whether a company has adequate cash flow to cover short-term debts and expenses. A healthy company should have a positive ratio.
Current assets are assets which are expected to be sold or otherwise used within one fiscal year. Typically, current assets include cash, cash-equivalents, accounts receivable, inventory, and prepaid accounts which will be used within a year, and short-term investments.
Current liabilities are considered to be the debts of the business that are to be settled in cash within the fiscal year. Current liabilities include accounts payables for goods, services, or supplies, short term loans, long-term loans with maturity within one year, dividends and interest payable, or accrued liabilities such as accrued taxes.
But one of the measures shortcomings is that current assets often cannot be liquidated in the short term. High working capital positions often indicate that there is too much money tied up in accounts receivable or inventory, rather than short-term liquidity. In those cases, it is best to work to collect payments from your customers and sell down inventory to increase your working capital.
Points all businesses need to remember:
- Working capital (also known as net working capital) is a financial metric that measures a company’s operating liquidity.
- Working capital is defined as current assets minus current liabilities. A positive position means that a company is able to support its day-to-day operations – i.e., to serve both maturing short-term debt and upcoming operational expenses.
- All companies should focus on the tight management of working capital. Inventory, accounts receivable and accounts payable are of specific importance since they can be influenced most directly by operational management.
- Companies can improve their working capital management are able to free up cash and thus can, for example, reduce their dependence on outside funding, or finance additional growth projects.
- If done right, working capital management generates cash for growth together with streamlined processes along the value chain and lower costs definitions apply.