What is Working Capital?
Working Capital is the cash available to the business for carrying out its day to day activities. It might include paying for labour wages, purchasing stock, paying short term creditors etc.
A healthy working capital position is a measure of both a company's efficiency and its short-term financial health.
The working capital ratio is calculated as:
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 (cash, accounts receivable and inventory).
Importance of Working Capital
- If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy.
- A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.
- Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.
Working Capital Management
Maintaining a stable working capital position in the business depends on the following factors
- Cash management
- Inventory management
- Debtors management
- Short term finances