In Finance, the word Capital is basically just another name for money. And of course, every business needs money to grow, become sustainable and survive, as do individuals. Just like we – individuals have a daily, weekly and monthly budget, companies and businesses do too. The name given to the money used by a company to run its daily operations is “Working Capital”.
So, what is Working Capital?
Financially speaking, Working Capital refers to the difference between the current assets and current liabilities of a business or company. In other words, it is the amount the money that is left after a business subtracts what it owes from what it has. Current assets simply refer to those assets that can easily be converted into cash including cash itself. These include cash at bank, short-term account receivables (unpaid bills of customers due within the year) and inventories of finished goods and raw materials. Current liabilities, on the other hand, are those debts a company is required to repay within the year, financially referred to as accounts payable.
So, the working formula for Working Capital is given as follows:
Working Capital can be used to measure the short-term financial health of a company as well as its operational efficiency
The Working Capital Ratio (WCR)
The Working Capital Ratio, as the name implies, is simply your working capital in ratio form. This means that when your current assets are divided by your current liabilities, the number you get is your Working Capital Ratio. It can be represented algebraically as follows:
The WCR represents the relative financial health of your company. A WCR that falls between 1.2 and 2 means that your company or business is financially healthy – you have just enough cash to pay off all your current liabilities. A WCR above 2 means that a good chunk of your current assets (cash) which you could be reinvesting is lying idle which is not good for business. A ratio below 1 indicates a negative working capital, which means that you do not have enough money to pay off your current debts.
The Working Capital Cycle (WCC)
Another important working capital concept is the Working Capital Cycle. This is the length of time a company takes to convert its working capital into cash. It is basically a combination of the length of time it takes to convert its inventory and receivables into cash less the number of time it takes to pay off its debts. Its formula is as follows:
A longer WCC means that cash is being tied up in working capital at the expense of investing and earning a return on it. This situation can be corrected by reducing the number of days it takes to collect receivables or increasing the number of days it takes to pay debts.
Working Capital Management
Because working capital plays a very important role in determining how financially healthy a business is, a concept which is of major interest to investors as it helps them decide whether their money will be better invested somewhere else; companies have to be able to use working capital themselves to make decisions. Such decisions are referred to as working capital management. Working Capital Management is the process of managing a company’s short-term assets and liabilities to ensure that the company can operate effectively and still have enough money to take care of its upcoming short-term debts and operational expenses
Importance of Working Capital
Understanding the concept of Working Capital is important for any finance professional as it helps in understanding the current financial position of the company. As has been discussed above, working capital can be used to measure the short-term financial health of a company. The concept of working capital can help one understand discounted cash flow analysis techniques and can also be used to create financial models. It can also be used to correct a company’s financial position to avoid potential liquidity problems which can eventually lead to bankruptcy.
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