Working capital is the difference between a company’s current assets, such as cash, accounts receivable (customers’ unpaid bills) and inventories of raw materials and finished goods, and its current liabilities, such as accounts payable.
It is a measure of a company’s liquidity, operational efficiency and its short-term financial health. If a company has substantial working capital, then it should have the potential to invest and grow. If a company’s current assets do not exceed its current liabilities, then it may have trouble growing or paying back creditors, or even go bankrupt.
To calculate working capital, compare a company’s current assets to its current liabilities. Current assets listed on a company’s balance sheet include cash, accounts receivable, inventory and other assets that are expected to be liquidated or turned into cash in less than one year. Current liabilities include accounts payable, wages, taxes payable, and the current portion of long-term debt. Current assets are available within 12 months. Current liabilities are due within 12 months.
It is in line with or higher than the industry average for a company of comparable size is generally considered acceptable. If not, it may indicate a risk of distress or default.
Changes Affect a Company’s Cash Flow
Most major new projects, such as an expansion in production or into new markets, require an investment in working capital. That reduces cash flow. But cash will also fall if money is collected too slowly, or if sales volumes are decreasing – which will lead to a fall in accounts receivable. Companies that are using their capital inefficiently can boost cash flow by squeezing suppliers and customers.
Things to Remember
– A company has negative working capital If the ratio of current assets to liabilities is less than one.
– High working capital isn’t always a good thing. It might indicate that the business has too much inventory or is not investing its excess cash.
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