Working capital is a simple measure of a company's ability to meet its short-term operating needs. When positive, it confirms that the business has sufficient cash to service its short-term debt, paying each payment as it falls due.
It is a indicator of the short and medium-term financial health of a company, and is therefore a metric that must be monitored to ensure the survival of the business. It may also indicate the ability to support growth without recourse to borrowing or other capital raising.
To calculate working capital, you need to be clear about the amount of current liabilities.:
This will be deducted from current assets, which are liquid assets such as cash, accounts receivable, and inventory.
Positive working capital is a reflection of a company that can meet its short-term debt obligations.. However, three points need to be made:
Working capital must be evaluated on a case-by-case basis, depending on the nature of the industry. For example, businesses that are seasonal (e.g. tourism and hospitality in beach locations or ski equipment hire) will require larger working capital to stay afloat during the off-season, which is not the case for businesses where there isn't such a large difference in turnover throughout the year.
Negative working capital is a reflection of a company's accounting where current liabilities exceed current assets..
This situation implies a business risk, who may not be able to meet their short-term obligations. Likewise, Extended periods of negative working capital can lead to bankruptcy and insolvency.
The ability to reduce accounts receivable due dates and extend payable days without incurring commissions or interest is the key to making money with the working capital fund.
The combination frees up cash, providing multiple short-term interest-free lines of credit. This type of strategy reduces net interest expenses and results in a direct increase in profitability.
Working capital can also become a source of short-term financing to help with various investments and take advantage of opportunities that would otherwise be beyond the business's reach. For example, improvements in inventory management can also increase managers' confidence in their inventory, thereby eliminating inefficiencies and mitigating the risk of inventory obsolescence.
However, although working capital offers a fairly accurate view of a company's health, it can sometimes be misleading and you need to know when. For example, positive working capital is good, but not if it is due to high receivables or inventory. In these cases, or when in doubt, it is worthwhile supplementing the analysis of a company's finances with a study of its cash conversion cycle.
