Working Capital

Working capital, also known as net working capital or NWC is the net liquid assets of your company — which is calculated by deducting current liabilities from the current assets. How much available working capital your business has is a sign and measure of its ability to meet its short-term obligations. Your online accounting and bookkeeping teams can help you count and analyze the figures.

Sources of working capital
Components of working capital
Working capital formula and working capital calculation
Working capital example
Working capital types
Working capital management
What influences working capital

Sources of working capital

Sufficient amount of the working capital allows you to take advantage of any unexpected opportunities and to have enough ground to qualify for bank loans and more favourable trade credit terms. Here are the sources of the working capital:

1. Net income
2. Long-term loans
3. Sale of capital assets
4. Stockholders’ injection of funds

Components of working capital

So, there are two things from your company operations that you need to count the working capital.

Current assets

It is what your company currently owns — and what can be converted to cash within a year (or less). Current assets include:

1. Cash and cash equivalents (such as stocks and bonds)
2. Accounts receivable (money your customers still owe to you)
3. Short term-investments
4. Inventory (your company’s goods, valued at the lowest cost or market price)
5. Prepaid expenses (such as advertising contracts, insurance or rent)

Current liabilities

Liabilities are what your company owes — and current are those that are due to be paid within a year. Current liabilities include:

1. Accounts payable (that is what you owe suppliers for what you have bought on credit)
2. Salary (the money you owe your employees for working hours that are already completed)
3. Loans that you must pay within a year
4. Taxes you owe

Working capital formula and working capital calculation

Working capital calculation is made with the help of the working capital formula and the figure you get is known as the working capital or current ratio.

Current ratio = current assets/current liabilities

A ratio below 1 would be seen as negative working capital, while a ratio above 1 means that your current assets exceed your liabilities and this is positive. A positive ratio means that your company can financially cover its current operations and also have enough funds to invest in future activities and growth. So, generally, the higher the ratio, the better. However, a high working capital might also be interpreted as not much of a good thing as it might be seen as a sign that your business has too much inventory or is not investing excess cash your company has.

Working capital example

Let’s examine the figures for cleaning company Dream&Dry.

For the fiscal year ending December 31, 2019, Dream&Dry has current assets valued at £1,5 million.

Cash and cash equivalents — £900,000

Short term-investments — £200,000

Advertising contracts — £100,000

Inventory — £150,000

Insurance — £150,000

Dream&Dry currents liabilities for the same period stand at £1 million.

Accounts payable — £250,000

Salaries — £400,000

Loans — £150,000

Taxes — £200,000

Applying the formula:

£1,500,000 (current assets) / £1,000,000 (currents liabilities) = 1,5

and that is the working capital or current ratio of Dream&Dry for 2019.

Working capital types

From a balance sheet point of view, working capital can be classified into net (current assets on the balance sheet minus current liabilities) and gross working capital (just current assets from the balance sheet).

From the operating cycle point of view, it can be broken down into temporary (the difference between net and permanent working capital) and permanent (fixed assets).

Working capital management

Working capital management is a business strategy that is aimed at keeping your company able to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. It is carried out by effective usage of your company’s current assets and liabilities. The management mostly involves keeping an eye on your inventories, accounts receivable and payable and cash and it helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC) — the minimum amount of time required to convert net current assets and liabilities into cash. Another goal of working capital management is to minimize the cost of money spent on working capital and to maximize the return on asset investments.

The working capital strategy involves tracking 3 ratios: the working capital ratio, the collection ratio and the inventory turnover ratio. Keeping these ratios at optimal levels ensures efficient working capital management.

We have analyzed the working capital ratio above, let’s focus on the other two.

The collection ratio

The collection ratio shows how efficiently your company manages the money your customers owe to you — or your accounts receivable. The formula of net sales/average accounts receivable shows how effective a company is in collecting debts and extending credits. A higher turnover rate shows that customers pay quicker and less money is tied up in accounts.

The inventory turnover ratio

Sufficient inventory should be kept to meet customers’ needs while avoiding unnecessary inventory that ties up working capital. That’s what the inventory turnover ratio is for. The formula to count it is the cost of goods sold /  average inventory and it shows whether a company has an excessive inventory in comparison to its level of sales.

What influences working capital

Analyzing the working capital is, though, more than just counting and comparing the ratios. The level and nature of working capital depend on the industry your company operates in or how the working process with customers and suppliers goes.

For example, if you receive payments from the customers quickly and via the Internet, you do not need much working capital. While little working capital will be insufficient for you if you offer, for instance, payment credit schemes to customers.

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