Before we go ahead and talk about the perfect formula for working capital, let us talk about what working capital exactly is. Working capital is also known as the net working capital of a company. It is the difference between the current assets of a company and the current liabilities of a company. It is right there in the title; it is the amount of money that is required to carry out everyday transactions. Working capital is simply the measure of the liquid financial health of a company. It usually translates to finances, liquid finances. If the current assets of a company do not exceed the current liabilities, it will have a lot of trouble growing or even paying back some of the loans that the company has taken. In some cases, the company even goes bankrupt.
To avoid that, most companies follow a beautiful formula. This formula has helped so many companies. To calculate the working capital, you should compare the current assets of a company to the current liabilities. The current assets which are listed on the balance sheet of the company happen to include accounts receivable, inventory, cash and some other assets which are expected to be liquidated or even turned into cash in less than just one year.
The current liabilities of the company will include Accounts Payable, taxes payable, wages and long-term debts. The current assets are available within the 12 months, and current liabilities are due within 12 months. Both are for one year. The standard formula for the working capital is current assets minus current liabilities. Working capital which is in line with or even higher than the industry average for a company of comparable size is generally considered to be acceptable. A low working capital may actually indicate some distress, default or some risks in a company.
As you know, a working capital is the measure of a company’s operational efficiency and also the short-term financial health of the very same company.
If there are any changes in working capital, it will affect the cash flow of the company. Most of the major new projects, like expansion into new markets, will always require a significant investment in working capital. This translates to a reduction in tax law. Cash will also fall if the money is collected too slowly or even of the sales volumes are decreasing significantly. This will lead to a fall in accounts receivable. Companies which are making use of working capital in an inefficient manner can actually boost the cash flow by squeezing some of the customers and suppliers.
Regulating working capital is certainly one of the most important things that a successful company should do.