Are you looking for an indicator that can measure the overall efficiency of an organization? Do you want to know about the liquidity of a company?
The best measure that indicates the liquidy of a company is its working capital. This means the current assets should be more than the current liabilities. As the name suggests, working capital is the capital that is available to a business entity for its day-to-day operations. It signifies whether the company has enough assets to cover its short-term dues and debts.
Working Capital is considered very reliable by financial experts as it can help to estimate the true financial position of that company. It also helps to foresee any probable difficulties that it might have to face later on.
What is Working Capital?
Working capital is used for measuring the ability of an organization to pay its present liabilities with present assets. It is a liquidity ratio that is calculated by simply deducting current liabilities from the current assets.
The concept has proved vital because it helps in understanding whether the company can pay its obligations without using long-term assets.
Current assets include cash, along with marketable securities and cash equivalents that can be converted quickly into cash to pay off the debts promptly.
Components of Working Capital
One of the most important things that creditors are interested in is in whether a business entity can generate receivables, revenues, and cash to pay for their current debts and obligations.
The amount that is available as working capital depicts the ability of a firm to meet its dues.
It is imperative to know about the sources of working capital so that you do not have to face any trouble later on. These can be spontaneous, short-term, and long-term sources.
The long-term working capital source includes
- Long-term loans
- Share capital
- Retained profits
- Provision for depreciation
The short-term working capital source includes
- Public deposits
- Cash credit
- Tax provision
- Inter-corporate loans
- Bills discounting
- Short-term loans
- Trade deposits
Spontaneous working capital is related to trade credit that includes
- Bills payable
- Notes payable
Working capital is an indicator of the liquidity level of a business entity and includes
- Accounts receivable
- Accounts payable
- Short-term debts
Factors affecting working capital
It is necessary to keep a certain amount of liquid cash and securities at hand that can be easily converted into liquid cash easily. Remember an organization can experience a shortage of cash even if it has a sufficient amount of current assets. This is because it is unable to convert the assets into cash.
- The working capital is also dependent on the industry to which it is related, its competitors, relationship with suppliers and its clients.
- Does the company have marketable securities that can be easily converted into cash
- If there is a no-credit policy, it will stop any borrowing. This will enable the company to operate on a daily basis with ease.
- If its customers are consistent in their payment, then the company will not have any difficulty in maintaining its working capital.
What are the current assets and current liabilities?
Current assets are those that are either in cash or can be easily converted into cash.
These assets provide benefits for a particular, fiscal year and include prepaid expenses, checking and savings account, marketable securities like ETFs, mutual funds, bonds and stocks, accounts receivable, inventories and cash. Remember that current assets do not include collectables, real estate, and hedge funds.
It is necessary to identify the section that lists current assets of the company in its balance sheet. All the assets are written in a particular order of liquidity. The current assets are at the top, just add all of them and derive the required total.
Current Liabilities are sort of dues and debts that you have to pay back within the financial year. These are short-term liabilities and includes expenses of day-to-day running like materials, supplies, utilities, and rent, accrued income taxes, interest on debts, accrued liabilities, capital leases that are due within that year, Long-term debt payment that is due that particular year, notes payable and accounts payable.
Just like the current assets, liabilities are also listed on the company’s balance sheet. The liabilities are mentioned in the order of due date so you will find all the current liabilities at the top. Add all the current ones after identifying them and then derive the required total.
The larger is the working capital, the greater is the chance that the organization can meet its obligations within the stipulated time and that too easily.
How To Calculate Working Capital?
It is vital to keep track of your current assets so that you have enough cash into your checking account.
If it is not possible to keep the cash in hand, then opt for a part of assets to be invested in securities that can be marketable quickly in times of need. This will provide the business entity with a better chance of meeting its liabilities on time.
In order to maintain and monitor working capital, you need to know the steps that must be taken to calculate it. There is a very easy formula that can help any entrepreneur to know about its working capital quickly. The formula for Calculate Working Capital is as follows
Working Capital Formula
Let me explain the concept of working capital with an example. A business entity XYZ has posted the figures of current liabilities and current assets at 220000 and 300000 respectively in its year ending balance sheet.
According to the reports mentioned its working capital can be estimated with the help of the formula
Working Capital = Current Assets – Current Liabilities
Working Capital = 300000– 220000
Working Capital = 80000
Thus the Calculate Working Capital of XYZ is Rs 80000 for that financial year.
Advantages of High Working Capital
Business entities that have high working capital are able to finance their acquisitions, take advantage of cash discounts, and carry inventory easily.
For example, if an entrepreneur has posted his working capital, current assets and current liabilities at Rs 200000, Rs 300000 and Rs 100000 respectively it means that after paying his current liabilities he still has 200000 as working capital which he can use for any other plan.
This shows that the company is highly liquid and is going strong day by day. When a firm has plenty of working capital, it has the upper hand in acquiring favourable terms for trade credit and bank loans. It can also grab the opportunities that come in its way for further growth and expansion.
Is the company on the verge of depleting its long-term assets, or is it able to pay all its current liabilities easily with the help of current assets is an important question?.
In case a company is unable to pay its liabilities with current assets, it will have to sell its revenue-generating long-term assets, and this will minimize its future revenues.
It will have a direct impact on the financial capabilities and hence will hamper the plans for expansion and growth. Insufficient capital can result in excessive pressure on the company, and it might lead to a rise in borrowing and late payments to vendors and creditors.
This will lower the credit rating, and now the company will have to pay higher rates of interest on whatever amount it borrows. Ultimately it leads to fewer revenues.
Remember, negative working capital is a sign of danger and indicates that the company is moving towards the red hence beware.
Types of Working Capital
According to the balance sheet, working capital can be classified into
1) Net Working Capital
Net Working Capital is a comprehensive study of the financial condition of a business entity. It is the difference between current assets and current liabilities of an organization for a particular, fiscal year.
Net Working Capital is used as a measuring tool to gauge the liquidity of a company and to determine whether it is capable enough to meet its obligations for that year.
2) Gross Working Capital
Gross Working Capital is the total sum of all the current assets of the company within a particular, fiscal year that can be converted into cash. It includes
- Marketable securities
- Short-term investments
- Accounts receivable
Calculate Working Capital basically is the amount a company has with it to meet daily operations. This financial metric gives us a clear picture of the financial condition as well as the stability of an organization.
If the current assets exceed the current liabilities, everything is well and good for the company, but if it is a case of a reverse story that is liabilities exceeding assets, then it is a sure sign of making changes so as to avoid further loss.
The larger difference between what you possess and what you are obliged to pay shows the healthy financial condition of the company.