Tavagapedia

Working capital

Key Takeaways

  • Working capital refers to the difference between a company’s current assets and its current liabilities
  • Net working capital change = Working capital of current year – Working capital of previous year
  • Working capital is the sum required by the enterprise for carrying out its day to day operations. 
  • It is considered good for a company’s financial health to have a positive working capital

What is Working Capital?

Working capital refers to the difference between a company’s current assets and its current liabilities. Working capital is the sum required by the enterprise for carrying out its day to day operations. Current assets include assets that can be easily sold, used or consumed through business operations like accounts receivables, cash, raw material and finished goods. Current liabilities include the short-term obligations that need to be fulfilled within one operating cycle like accounts payable.

Working capital is the sum required by the enterprise for carrying out its day to day operations. Net working capital measures a company’s operational efficiency, liquidity and short-term financial health.

It is considered good for a company’s financial health to have a positive working capital. If working capital is negative, then the company may face problems in paying back its short-term debtors and carrying all the operations smoothly. Having a negative working capital for prolonged duration can hamper growth prospects and even lead to bankruptcy.

How to calculate Working Capital?

For calculating the working capital, a company’s current assets are compared with its current liabilities where current assets include accounts receivables, inventory, cash and other assets that will most probably liquidate within a year or an operating cycle. Current liabilities are the financial obligations of a company like accounts payables, wages and current portion of long-term debts and are due within one operating cycle or a year.

Working Capital = Total Current Assets – Total Current Liabilities

It is considered good to have working capital in sync with the industry standards or higher. Having low or negative working capital may be a sign of financial distress or default.

 How to calculate changes in Working Capital?

Working capital change refers to the change in net working capital from one accounting period to that of another accounting period. It helps in ensuring that in every accounting year, sufficient level of working capital is with the company.

Change in working capital can be calculated using the formula:

Net working capital change = Working capital of current year – Working capital of                              previous year

Or

Net working capital change = Change in current asset – Change in current liabilities

 Steps for calculating Working Capital Change

1.     Note down the total current assets of the current and the previous year, which can fall under:

·       Accounts Receivables

·       Cash

·       Inventory

·       Prepaid Expense

2.     Note down the total liabilities of current as well as the previous year, which will usually fall under:

·       Accounts Payable

·       Deferred Revenue

·       Interest Payable

·       Wages

3.     Calculate the working capital for current as well as previous year.

·       Working capital of current year = Current assets of current year – Current liabilities of current year

·       Working capital of previous year = Current assets of previous year – Current liabilities of previous year

4.     Find out the Net Working Capital Change using the formula:

Net working capital change = Working capital of current year – Working capital of previous year

Example of Working Capital

At the end of 2021, ABC company reported Rs. 1,00,000 of current assets. The company also reported Rs. 4,00,000 of current liabilities. Therefore, at the end of 2021, ABC company’s working capital metric was Rs. 6,00,000.