Working capital is the day-to-day finance for running a business and is used to measure a firm's ability to meet current obligations, such as the payment of wages, electricity and rent. A high level of working capital indicates significant liquidity. It is also called net current assets or net working capital.
Every business needs money, cash, to keep it operating. Money is the lifeblood of business to meet day-to-day expenses and to pay bills, as and when they come due. If key bills, such as those for rent and energy are left unpaid, the firm may be declared insolvent. Indeed, a lack of cash, rather than insufficient profit, is the main reason for business failure.
Working capital is calculated by using the formula:
Current Assets are assets that are intended to be turned into cash within the present financial year. Typically current assets comprise stock, debtors and cash.
- Stock is the least liquid of current assets. It comprises of stocks of raw materials (components), semi-processed goods (work in progress) and finished goods. In some countries stock is called inventory.
- Debtors are people or organisations that owe money to the business as the result of buying goods or services on credit. It is an asset, because the firm should eventually receive payment.
- Cash is the most liquid asset. It is held in the organisation or in the bank (cash-in-hand or cash-at-the-bank). All other assets are measured against it to define liquidity.
Current Liabilities are anything owed by the organisation, which is likely to be paid within the present financial year. Typically current liabilities comprise an overdraft, creditors, dividends and unpaid tax.
- An overdraft is a facility given to an organisation that allows it to raise short term finance by having a negative balance on its accounts up to an agreed limit. In essence it is a short term bank loan.
- Creditors are suppliers to whom the organisation owes money because it has bought goods and services on credit.
- Dividends are a share of the profits due to shareholders as a reward for purchasing shares, but have not yet been paid.
- Tax may be owed to the government for a variety of reasons, such as a percentage of profits.
Having too much working capital can be considered a problem, because there is an opportunity cost associated with surplus working capital tied up in stocks, debtors and cash. Current assets, such as cash, could have earned returns elsewhere in the business. For instance, cash could be invested in new fixed assets which would generate future sales. So there is a balance to be made between too many, and too few, liquid assets.
Do you know the difference between bankruptcy and voluntary liquidation? This money for the day-to-day operation of a business, and its survival, is known as working capital. Working capital control is vital to the survival of businesses.