Working capital is the amount by which the value of a company's current assets exceeds its current liabilities. Also known as net working capital. Sometimes the term "working capital" is used as a synonym for "current assets", but more often it is used as "net working capital", i.e. the amount of current assets in excess of current liabilities. Working capital is often used to measure a company's ability to meet current obligations. It measures how much liquid assets a company has available to build its business.
Working capital is a common measure of a company's liquidity, efficiency, and overall health.
Decisions related to working capital and short-term financing are referred to as working capital management. It involves managing the relationship between a company's short-term assets ( inventories, accounts receivable, cash) and its short-term liabilities.
Working capital (net working capital) = Current Assets - Current Liabilities
Both variables are shown on the balance sheet (statement of financial position).
Norms and Limits
The number can be positive (acceptable values) or negative (uncertain values), depending on how much debt the company has. Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately. In general, companies with high working capital are more successful because they can expand and improve their operations.
Companies with negative working capital may lack the funds to grow. Analysts are sensitive to declines in working capital; they suggest that a company is overleveraged, struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too slowly. Although in some businesses (such as grocery retailing), working capital can be negative (such a business is financed in part by its suppliers).
Exact Formula in the ReadyRatios Analysis Software
Working capital (net working capital) = F1[CurrentAssets] – F1[CurrentLiabilities]
F1 – Statement of financial position (IFRS).
Working Capital Management
Working capital management is the process of managing a company's short-term assets and liabilities in order to ensure that it has enough liquidity to meet its day-to-day obligations. There are several main approaches to working capital management, including:
The conservative approach: This approach involves maintaining high levels of cash and cash equivalents, while keeping levels of accounts receivable and inventory low. This approach is best for companies that operate in a volatile or uncertain environment.
The aggressive approach: This approach involves maintaining low levels of cash and cash equivalents, while keeping levels of accounts receivable and inventory high. This approach is best for companies that operate in a stable environment and have a high level of customer demand.
The match funding approach: This approach involves matching the maturities of a company's short-term assets and liabilities. For example, a company might use short-term debt to finance short-term assets such as inventory. This approach is best for companies that have a predictable cash flow.
The Operating Cycle Approach: This approach involves managing the length of the operating cycle, which is the time it takes for a company to convert its raw materials into cash. A shorter operating cycle means that a company can generate cash more quickly, which can help to improve its liquidity.
The Net Working Capital Approach: This approach involves managing the difference between a company's current assets and current liabilities. A company with a positive net working capital has more current assets than current liabilities and is considered to be in a strong financial position.
It's important to note that the best approach will depend on the company's industry, its business model and the overall market conditions. It's also important to strive for a balance between liquidity and growth, and not to compromise one for another.