Basics: What is Working Capital

Efficient working capital management is critical for the growth of an organization.
By Morningstar |  11-10-19 | 
 

Management of Working Capital is one of the most important functions of corporate management.

On one hand, WC is important to because it is a measure of a company's ability to pay off short-term expenses or debts. 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.

Efficient working capital management is crucial in maintaining survival, liquidity, solvency and profitability of the organization.

What is it?

Working capital is the money required to run the day-to-day operations of a business.

How is it calculated?

Working capital is calculated as current assets minus current liabilities. If the current assets are Rs 3.23 crores and current liabilities are Rs 3.10 crores, the company’s working capital is Rs 13 lakhs.

Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets.

It is expressed as a ratio. Current Assets / Current Liabilities = Working Capital Ratio

Company A

  • Assets = Rs 40 lakh
  • Liabilities = Rs 20 lakh
  • Working Capital Ratio = 2:1

Company B

  • Assets = Rs 80 lakh
  • Liabilities = Rs 46.25 lakh
  • Working Capital Ratio = 1.7:1

What does it tell you?

It is a measure of both, a company's efficiency and its short-term financial health. It will tell you whether the company has sufficient short-term assets to take care of short-term debt and financial obligations.

Ideally, a company’s assets should exceed its liabilities. If not, that would spell trouble when it comes to paying back creditors. This could set them on the path to bankruptcy.

Is there an ideal number?

Ideally, a working capital ratio between 1.2 and 2.0 should be fine.

If a business has a working capital ratio below 1.0, it could mean significant liquidity issues or isn't productive enough compared to how much debt it’s taking on. That’s a red flag.

On the other hand, higher than 2.0 need not be better as it could indicate that a company is not doing a good job of employing its assets to generate maximum possible revenue.

What additional points must you note?

Every organization whether public or private, profit oriented or not, irrespective of its size and nature of business, needs adequate amount of working capital. The favourable ratio will depend on the industry in which the company operates.

It will also depend on the nature of the company's sales. Let’s say its sales are growing, or at least consistent, over the internet and are paid for via net banking or credit and debit cards at the time the order is placed. Then a small amount of working capital may be sufficient. The same figure may not be true for another company that operates differently.

As working capital is defined as current assets over current liabilities, at the time of determination of working capital, quality of current assets especially size of debtors and inventory are important factors. Hence, another factor to note are the type of current assets owned and how quickly they can be converted to cash. A marketable security can be converted into cash much faster than inventory. Examples of assets are cash, accounts receivable, inventory, supplies, land, buildings, and equipment. Assets are considered current assets when they are expected to be liquidated into cash or be used within one year.

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