What Exactly Does Working Capital Mean?

Working capital is actually a very simple concept. Working capital is something that is required by every single company to carry day to day activities. A healthy business will always have enough capacity to pay off all its liabilities with the help of its assets. If it has a ratio above one, it means that the assets of the company can actually be converted into cash at a much faster pace. If the ratio is higher, the company is more likely to honour the short-term liabilities and all the commitments to debts.

Keep in mind that a higher ratio also means that the company can easily fund all of its operations. It will not have to depend on loans or anything else. If the company has more working capital, it is less likely to be in debt, and it is more likely to fund the growth of its businesses. If the working capital keeps increasing, the business can grow exponentially. The profits will also turn in a positive manner, and the business can grow.

If the company has a ratio of less than one, it is considered very risky by the investors and the creditors, since it demonstrates that the company may not exactly be able to cover its debt, if need be. A current ratio of less than one is also known as a negative working capital, and it is something that you should be afraid of, because it borders on bankruptcy. Bankruptcy is the last straw that a company can draw, and it is one of the worst things to happen to a company.

A stringent ratio is definitely a quick ratio, and it measures the proportion of any short-term liquidity as compared to the current liabilities. The difference between this and the current ratio is also called the numerator, where the asset side always includes cash, receivables and some kinds of securities that are marketable. Quick ratio would exclude inventory, which can definitely be more difficult to turn into cash if we are talking about a short-term basis.

Here is a simple example of working capital.

If we consider current assets and if the cash is valued at $20,000, accounts receivable is valued at $15,000, and inventory is valued at $45,000, we can conclude that current assets are worth $80,000. Now current liabilities are worth $40,000. Accounts payable is $25,000, short-term borrowings are $5000 and accrued liabilities are $10,000. Working capital is valued at $40,000. It is a very simple formula.

The formula for working capital is current assets minus current liabilities. In this case, it happens to be $80,000 -$40,000=$40,000.

A company can easily increase the working capital by selling more products.