BNET Basics

Assessing Your Working Capital

by BNET Editorial

Tags: asset, working capital, managerial accounting, asset management, finance, operational planning, business operations

Working capital is the money available to fund a company�s day-to-day activity. Essentially, it�s the cash�plus assets that can quickly be converted to cash�that is readily available and not committed elsewhere. The formula for working capital is total net current assets (inventory, accounts receivable, cash etc)�minus current liabilities (debts, salaries, interest payments, accounts payable etc).

Without the resources to fund the daily operation of its business, to pay staff, to meet debts and to invest in growth, a company will quickly run into the ground. And the more quickly it grows, the more working capital it requires.

Many businesses fail not because they fail to make profits, but because they have insufficient working capital. It�s essential that current assets are always ahead of current liabilities.

What to Do

The formula for working capital is simply:

current assets � current liabilities

Also known as liquid assets, current assets include cash, inventory, and accounts receivable, and any assets that are expected to be turned into cash within one year. Current liabilities are the debts that a business expects to pay within one year.

Suppose a company�s current assets amount to $700,000 and its current liabilities are $380,000 in total. Working capital is therefore:

$700,000 � $380,000 = $320,000

The working capital cycle tracks the movement of capital (typically cash, in which case it�s also known as the cash cycle) through a business. First, it flows out of the business to fund supplies, equipment, materials, and inventory�and to pay staff. Then it flows back in, as the company sells its goods and services, and receives new sources of funding from equity and loans. Each of these processes takes time, and the longer they take, the heavier the strain on a company�s working capital.

What You Need to Know

Companies can boost their working capital by collecting receivables promptly, moving inventory faster, and generating more cash.
Paying cash for fixed assets like equipment or machinery means there�ll be less available for working capital.
Capital investment can be funded through loans, leases or equity rather than drawing on working capital.
A company having trouble managing its working capital effectively is constantly diverted by cash emergencies. Possible indications of trouble include: attractive discounts to customers who pay promptly or in advance; additional loans; part or late payment of bills; last-minute visits to the bank for short-term advances�perhaps to pay staff or in lieu of expected income.
A number of key financial ratios draw on working capital, and are useful to investors wanting to assess the effectiveness and efficiency of its use.