Working Capital

Dear All,

Just a little something on Working Capital:

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has aworking capital deficiency, also called a working capital deficit.

Working Capital = Current Assets

Net Working Capital = Current Assets − Current Liabilities

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable and cash.

If a company's current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company's sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.

Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner (slow collection), it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

CONCEPTS OF WORKING CAPITAL

There are two concepts of working capital:

a.              Gross working capital: It is equal to the total investment in current assets.

b.             Net working capital: It is the difference between current assets and current liabilities. It can be described as that part of a firm’s current assets which is financed with the help of long-term funds.

Both the concepts have equal significance in working capital management.

Gross working capital helps in analyzing:

a.              Ways to optimize investment in current assets and

b.             Methods for financing current assets.

Net working capital indicates the liquidity position of the firm. It also reflects the extent to which the working capital needs should be financed by long-term sources of funds.

Current assets are those assets that, in ordinary course of business, can be converted into cash within one year without undergoing any diminution in value. The major current assets are cash, marketable securities, accounts receivable, and inventory.

In contrast to this, fixed assets are those assets that are permanent in nature and are held for use in business activities. For example, land, building, machinery etc.

Current liabilities are those liabilities that are obligations that have to be paid in a single accounting period. Examples of current liabilities are: accounts payable, bills receivable, bank over-draft and outstanding expenses. Long-term liabilities, on the other hand, are obligations that can be repaid over a period greater than a single accounting period. Examples of long-term liabilities are: share capital, debentures, long-term loans etc.

For more information visit http://en.wikipedia.org/wiki/Working_capital

Thanks and Regards,

Pranav Vaidya

Article Assistant

Gokhale & Sathe

Chartered Accountants