There are several technical definitions of working capital, some being complex and difficult to break down. However, the simple definition of working capital can be given as the money that is available for a firm to meet its current, short term obligations. It can also be defined as the difference between a company’s current assets and current liabilities. It is a tool used to measure financial performance of a company by calculating whether the company has enough liquid assets to meet its short-term financial obligations such as payment of bills and salaries.
A company’s current assets include cash and cash equivalents, inventory, accounts receivable (debtors), and marketable securities. These are the assets that a company can easily convert into cash use to pay short term financial obligations.
Current liabilities are the amount of money that a business owes, such as creditors (accounts payable), short-term loans, and accrued expenses.
Working capital is derived by subtracting current liabilities from current liabilities as shown below:
In the figure, the total current assets of the firm is $80,000 while the total current liabilities is $40,000. This gives a working capital of 80,000-40,000 = 40,000.
Working capital is the measure of a firm’s liquidity, which refers to the ability to meet short term obligations as they fall due. It can be used in financial analysis to assess the company’s performance. A company that has a high working capital is able to meet its financial debts. It means that the firm has enough liquid assets that can be used to pay off bills; hence the firm can pay creditors, employees, suppliers, and other short term financial obligations.
A positive working capital is a good sign which shows that the firm has a good financial health, at least in the short term. A company that has a positive working capital can be able to run its operations effectively; it shows that the company’s operations are efficient, and the company can internally pay for its bills and finance business growth. However, a negative working capital means that the firm’s current assets are not sufficient to pay off all current liabilities. As a result, the firm has to borrow to meet its short-term financial obligations. As debts increase, so do financing costs. This shows a negative financial position for the company, which may not be good for the company’s operations and relations with shareholders.
The amount of working capital a company has will typically depend on its industry. Some sectors that have longer production cycles may require higher working capital needs as they don’t have the quick inventory turnover to generate cash on demand. Alternatively, retail companies that interact with thousands of customers a day can often raise short-term funds much faster and require lower working capital requirements.
