Working Capital

Working Capital

Working Capital is defined as Current Assets minus Current Liabilities.

Current Assets are mainly Inventory, Accounts Receivable (Debtors), Cash and Bank Balances, other debtors and prepayments.

Current Liabilities are mainly Accounts Payable (Creditors), Bank Borrowings, Other Liabilities such as Accrued Expenses. Bank Borrowings are short term borrowings or part of long term borrowing which are repayable within a year.

When Current Assets is greater than Current Liabilities it is known as Positive Working Capital. When a company has positive working capital it would generally mean that the company is handling its operations well enough to meet its short term obligations. It speaks about the efficiency with which it is managing its day to day operations.

When Current Liabilities is greater than Current Assets it is known as Negative Working Capital. One of the interpretations would be that the company does not have sufficient funds to run the day to day business and thus may have to rely on introduction of funds by owners or long term borrowings to meet its operational requirement.

Formula of Working Capital

Working Capital = Current Assets – Current Liabilities.

Example of Working Capital

• Abstract from the Balance Sheet as on 31-12-07
• Stock – $ 25,000
• Debtors – $ 35,000
• Cash In Hand – $ 2,000
• Other Debtors and Prepayments – $ 12,000
• Creditors – $ 28,000
• Bank Borrowings – $ 15,000
• Accrued Expenses & Other Liabilities – $ 6,000
• Working Capital = Current Assets – Current Liabilities
• Current Assets = Stock + Debtors + Cash In Hand + Other Debtors and Prepayments
• Current Assets = 25,000 + 35,000 + 2,000 + 12,000
• Current Assets = $ 74,000
• Current Liabilities = Creditors + Bank Borrowings + Accrued Expenses & Other Liabilities
• Current Liabilities = 28,000 + 15,000 + 6,000
• Current Liabilities = $ 49,000
• Working Capital = 74,000 – 49,000
• Working Capital = $ 25,000

The Working Capital amounts to $ 25,000. It means that the company is able to meet its daily operational requirement. The business appears to be self sufficient. The cash generated from operations over a period of a year or two can be utilized to purchase fixed assets and other expansion to grow the business.

Companies and investors would also compute the Current Ratio after calculating the Working Capital. Current Ratio is Current Assets divided by Current Liabilities. Thus in this case the Current Ratio is

• Current Ratio = Current Assets / Current Liabilities
• Current Ratio = 74,000 / 49,000
• Current Ratio = 1.5

The Current Ratio needs to be compared with the industry standards. For most industries the Current Ratio between 1.5 to 2 is considered good.

Working Capital Management

It is important for any organization to manage its Working Capital, a skill which a Finance Professional needs to possess.

The major elements in the working capital requirement which need to be managed are

• Inventory – Inventory needs to be kept at a reasonable level which is not too high to result in non moving stock nor too low such that the company suffers stock outs. The factors in determining the inventory to be stored are Reorder Level, Minimum Level, Maximum Level and Economic Order Quantity.
• Debtors – The credit period enjoyed by the Customers needs to be defined. Customers are required to pay within the credit period. The receivables need to be followed up on maturity for collection.
• Creditors – The payment terms need to be well negotiated with the creditors. This usually depends upon the product purchased.

However it cannot be stated that if the working capital is high the business is managed efficiently. There needs to be balance between the Current Assets vis-à-vis the Current Liabilities. An increase in Current Assets could also mean that the business is not able to collect its debts on time or has Inventory piled up which they are not able to sell. Each element in the Working Capital calculation (stock, debtors, creditors) has its own relevance and needs to be managed.