A business’s working capital is a reflection of its ability to pay current liabilities with its existing current assets. Maintaining it is essential for any business as it is one of the most important parts of the total capital in any business industry, as it allows them to operate while maintaining liquidity of the organisation efficiently and helps meet the current financial obligations of the business.
Working capital is an essential part of the total capital As per the working capital meaning, it is represented as the ability of a business’s current assets to meet or pay for its current liabilities. In other simple words, it also represents the company’s financial health and lends creditors a view on how efficiently the company will be able to meet its short-term liabilities. Periodic calculation of working capital thus becomes a necessity for businesses so that they can assess and review their financial health and make essential changes in time. However, before moving on to the calculations, it is crucial to have a detailed idea of working capital meaning.
Working capital – An overview
Working capital comprises the difference between current assets and current liabilities and may result in a positive or negative balance. Also, you may calculate different types of working capital for specific purposes. It is also known as net working capital.
Optimum working capital ensures a business has the required liquid assets that can sufficiently pay the bills within the next 12 months. An asset’s ability to convert into cash or cash-equivalent determines its liquidity.
Based on the life cycle of working capital, its requirement for businesses may differ depending on their size, type of operation, operating cycle, and such other factors. While the working capital meaning comprises these details, below is given the calculation process by which you can compute the working capital of your organisation.
Difference Between Working Capital and Net Working Capital:
The health of a company’s capital indicates its financial status. Companies must possess adequate working capital (Working Capital) to support growth and future business operations.
The difference between working capital and net working capital:
- Principle of Working Capital and Net Working Capital:
Working Capital (Working Capital) is often referred to only current assets whereas, the net working capital (Net Working Capital) is taken as the difference between the current assets and current liabilities.
An increase in Working Capital is viewed as cash outflows since this cash cannot be utilised elsewhere and also earns no returns.
Net Working Capital is more accurate and a comprehensive measure of a business’ liquidity health. A business’s current liabilities are deducted from current assets for working capital calculation. You can find the current liabilities and assets listed on the year’s Balance Sheet. Below a discussion placed in numerical terms, which will easily help you to identify and describe the net working capital.
Calculation of Net Working Capital = All Current Liabilities – summing up the current assets of a firm (cash + short term investments + inventories + accounts receivable)
The total summation of a business’ current assets is known as gross working capital. Liabilities are not involved in this calculation. It, thus, offers a restricted account of the financial status.
Importance of Working Capital & Net Working Capital:
Working Capital is used to pay for overhead costs, raw materials, salaries, financial expansion and to handle unexpected expenses.
The Net Working Capital is essential to track business progress as the ratio between the current assets and liabilities speak about the liquidity condition.
Working Capital cycle or the working capital cycle refers to the time taken to turn current assets as well as liabilities into cash. Many of us surprised how the business efficiency can be increased with WCC then logically it can be said that, if companies will try to reduce their Working Capital as the longer they stretch, the longer the business remains tied up with it without earning any return.
Calculation of working capital in 3 easy steps:
Step 1 – Calculate the total current assets of your business
A current asset can be defined as the property your company presently owns, and which will be converted into cash within the next year. Current assets include the likes of inventories, marketable securities, savings, accounts receivables, etc.
You can find these assets in the right column of balance sheet under the head ‘Current Assets’. Find the sum of these assets to arrive at the total current asset present in your business.
Step 2 – Calculate the total of current liabilities
Amount due to be paid in the next 1 year can be specified as a total current liability. The list of current liabilities comprises accounts payables, short-term debts, utility bills, rent, tax and interest payable, etc.
Similar to current assets, you can find current liabilities listed on the left of your business’s Balance Sheet under the head ‘current liabilities’.
Step 3 – Use the working capital formula to arrive at the net amount
Once you calculate the total of CA and CL, utilise the method given below to calculate working capital.
Net Working Capital (Net Working Capital) = Current Assets (CA) – Current Liabilities (CL)
Once you calculate it, the result may be positive or negative. While a positive value indicates that the business has sufficient working capital to meet its current liabilities, a negative value means the business is short of necessary finance and requires outside funding.
If there is a working capital shortage, businesses have an option to avail additional finances to meet any deficiency in working capital requirement.
They can do so by securing customised business loans like working capital loans from reputed lenders in the market. These loans come with multiple attractive features and benefits, along with competitive interest rates that make repayments affordable.
With this insight on working capital meaning and calculation, you can now proceed to calculate the same for your business. The calculation is primarily helpful for small businesses as working capital can make or break a small business. This computation also helps a business analyse its financial health, and necessary measures can be taken to ensure that it never runs out of working capital. Read For Gratuity Calculation