Definition
Working capital is a financial metric which represents operating liquidity available to a business, organisation or other entity, including governmental entities. Along with working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
What is Working Capital?
Working capital is an important financial term. It gives the measure of the assets that are available to an organization for immediate expenditure. The commonly explained formula used to represent working capital is:
Working Capital=Current Assets-Current Liabilities
Working Capital Ratio
The working capital ratio is also used to describe the balance between the payments, and the availability of the short term assets that a company has to perform such payments. The ratio is simply calculated by dividing current assets by current liabilities, and a positive number shows that the company has a healthy ratio of producing working capital that allows companies to take important business steps such as performing expansion.
A negative working capital ratio though is not necessarily a bad thing. It may actually mean that the company has done long term investment, and it is going through a developmental phase.
A larger ratio of usually over two expresses that the company is not well maintained, and has assets that are not being used to generate further business income. The best working capital ratio according to experts should lie between the values one and two.
Explaining Working Capital
A company cannot operate with a negative capital ratio for long. It will fail to pay off its creditors once it starts to have a negative working capital. If the situation continues, the company may find itself in a condition for bankruptcy. A slowly decreasing working capital should alarm investors, which must look into the reasons behind such a trend. Usually it is a sign of a company running into problems with an increase in the volume of sales.
The company will show a huge ratio if it is not operating very efficiently, because it will then have more than the required inventory, and the money available as the working capital would show poor distribution as most of the money must be invested as assets in order to maximize company profits. Slow collection companies also do not perform well over the passage of time, and show that they are not able to efficiently use the sum already available to them.
The Best Investment
Investors usually like to invest in companies with moderate working capital ratios that are making profits, and still require new investments to expand operations. Such companies usually have a working capital ratio that is just above one, which is showing that the company is making profits, but do not have dormant resources, which are not being used in a business activity.
Further Reading
- Working capital and fixed investment: new evidence on financing constraints – www.jstor.org [PDF]
- Effects of working capital management on SME profitability – www.emerald.com [PDF]
- The relationship between working capital management and profitability: Evidence from Saudi cement companies – www.journaljemt.com [PDF]
- How does working capital management affect the profitability of Spanish SMEs? – link.springer.com [PDF]
