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Working capital (WC) is a financial metric which represents operating liquidity available to a business, organisation, or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as
current assets In accounting, a current asset is any asset which can reasonably be expected to be sold, consumed, or exhausted through the normal operations of a business within the current fiscal year or operating cycle or financial year (whichever period is ...
minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit and negative working capital. A company can be endowed with
assets In financial accounting, an asset is any resource owned or controlled by a business or an economic entity. It is anything (tangible or intangible) that can be used to produce positive economic value. Assets represent value of ownership that ca ...
and
profitability In economics, profit is the difference between the revenue that an economic entity has received from its outputs and the total cost of its inputs. It is equal to total revenue minus total cost, including both explicit and implicit costs. It ...
but may fall short of
liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity, the ease with which an asset can be sold * Accounting liquidity, the ability to meet cash obligations when due * Li ...
if its assets cannot be readily 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.

# Calculation

Working capital is the difference between current assets and current liabilities. It is not to be confused with trade working capital (the latter excludes cash). The basic calculation of working capital is based on the entity's gross current assets. $\text = \text - \text$

## Inputs

Current assets and current liabilities include four accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact: *
cash and cash equivalents Cash and cash equivalents (CCE) are the most liquid current assets found on a business's balance sheet. Cash equivalents are short-term commitments "with temporarily idle cash and easily convertible into a known cash amount". An investment norma ...
(current asset) *
accounts receivable Accounts receivable, abbreviated as AR or A/R, are legally enforceable claims for payment held by a business for goods supplied or services rendered that customers have ordered but not paid for. These are generally in the form of invoices raised ...
(current asset) *
inventory Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying the sha ...
(current asset), and *
accounts payable Accounts payable (AP) is money owed by a business to its suppliers shown as a liability on a company's balance sheet. It is distinct from notes payable liabilities, which are debts created by formal legal instrument documents. An accounts payable ...
(current liability) The current portion of
debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...
(payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit. An increase in net working capital indicates that the business has either increased
current assets In accounting, a current asset is any asset which can reasonably be expected to be sold, consumed, or exhausted through the normal operations of a business within the current fiscal year or operating cycle or financial year (whichever period is ...
(that it has increased its receivables or other current assets) or has decreased current liabilities—for example has paid off some short-term creditors, or a combination of both.

# Working capital cycle

## Definition

The working capital cycle (WCC), also known as the cash conversion cycle, is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer this cycle, the longer a business is tying up capital in its working capital without earning a return on it. Companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. Under certain conditions, minimizing working capital might adversely affect the company's ability to realize profitability, e.g. when unforeseen hikes in demand exceed inventories, or when a shortfall in cash restricts the company's ability to acquire trade or production inputs.

## Meaning

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize
free cash flow In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets (known as capital expenditures). It is that porti ...
. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30-day cycle usually needs to be funded through a bank operating line, and the interest on this financing is a carrying cost that reduces the company's profitability. Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow. Sophisticated buyers review closely a target's working capital cycle because it provides them with an idea of the management's effectiveness at managing their balance sheet and generating free cash flows. As an absolute rule of funders, each of them wants to see a positive working capital because positive working capital implies there are sufficient current assets to meet current obligations. In contrast, companies risk being unable to meet current obligations with current assets when working capital is negative. While it's theoretically possible for a company to indefinitely show negative working capital on regularly reported
balance sheet In financial accounting, a balance sheet (also known as statement of financial position or statement of financial condition) is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a busine ...
s (since working capital may actually be positive between reporting periods), working capital will generally need to be non-negative for the business to be sustainable Reasons why a business may show negative or low working capital over the long term while not indicating financial distress include: * Assets above or liabilities below their true
economic value In economics, economic value is a measure of the benefit provided by a good or service to an economic agent. It is generally measured through units of currency, and the interpretation is therefore "what is the maximum amount of money a speci ...
*
Accrual basis accounting Accrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. Accruals in accounting For example, a company delivers a product to a customer who will pay for it 30 days l ...
creating deferred revenue while the
cost of goods sold Cost of goods sold (COGS) is the carrying value of goods sold during a particular period. Costs are associated with particular goods using one of the several formulas, including specific identification, first-in first-out (FIFO), or average cost ...
is lower than the revenue to be generated ** E.g. a
software as a service Software as a service (SaaS ) is a software licensing and delivery model in which software is licensed on a subscription basis and is centrally hosted. SaaS is also known as "on-demand software" and Web-based/Web-hosted software. SaaS is c ...
business or newspaper receives cash from customers early on, but has to include the cash as a deferred revenue liability until the service is delivered. The cost of delivering the service or newspaper is usually lower than revenue thus, when the revenue is recognized, the business will generate gross income.

# Working capital management

Decisions relating to working capital and short-term financing are referred to as ''working capital management''. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its
operations Operation or Operations may refer to: Arts, entertainment and media * ''Operation'' (game), a battery-operated board game that challenges dexterity * Operation (music), a term used in musical set theory * ''Operations'' (magazine), Multi-Ma ...
and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses. A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets, and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

## Decision criteria

By definition, working capital management entails short-term decisions—generally, relating to the next one-year period—which are "reversible". These decisions are therefore not taken on the same basis as capital-investment decisions ( NPV or related, as above); rather, they will be based on cash flows, or profitability, or both. *One measure of cash flow is provided by the
cash conversion cycle In management accounting, the Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. It is thus a measure of the liquidity risk entailed by grow ...
—the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. *In this context, the most useful measure of profitability is
return on capital Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies relative to the amount of capital invested by sharehold ...
(ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed;
return on equity The return on equity (ROE) is a measure of the profitability of a business in relation to the equity. Because shareholder's equity can be calculated by taking all assets and subtracting all liabilities, ROE can also be thought of as a return on '' ...
(ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the
cost of capital In economics and accounting, the cost of capital is the cost of a company's funds (both debt and equity), or from an investor's point of view is "the required rate of return on a portfolio company's existing securities". It is used to evaluate ne ...
, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See economic value added (EVA). *Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the
cash conversion cycle In management accounting, the Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. It is thus a measure of the liquidity risk entailed by grow ...
.

## Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the ''current assets'' (generally
cash In economics, cash is money in the physical form of currency, such as banknotes and coins. In bookkeeping and financial accounting, cash is current assets comprising currency or currency equivalents that can be accessed immediately or near-i ...
and
cash equivalents Cash and cash equivalents (CCE) are the most liquid current assets found on a business's balance sheet. Cash equivalents are short-term commitments "with temporarily idle cash and easily convertible into a known cash amount". An investment normal ...
,
inventories Inventory (American English) or stock (British English) refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation. Inventory management is a discipline primarily about specifying the sha ...
and
debtor A debtor or debitor is a legal entity (legal person) that owes a debt to another entity. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor. When the counterpart of thi ...
s) and the short-term financing, such that cash flows and returns are acceptable. * Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. *Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials—and minimizes reordering costs—and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce
Work in Process Work in process (WIP), work in progress (WIP), goods in process, or in-process inventory refers to a company's partially finished goods waiting for completion and eventual sale, or the value of these items. The term is used in supply chain managem ...
(WIP) and similarly, the
Finished Goods Finished goods are goods that have completed the manufacturing process but have not yet been sold or distributed to the end user. Manufacturing Manufacturing has three classes of inventory: # Raw material # Work in process # Finished goods A ...
should be kept on as low level as possible to avoid
overproduction In economics, overproduction, oversupply, excess of supply or glut refers to excess of supply over demand of products being offered to the market. This leads to lower prices and/or unsold goods along with the possibility of unemployment. The ...
—see
Supply chain management In commerce, supply chain management (SCM) is the management of the flow of goods and services including all processes that transform raw materials into final products between businesses and locations. This can include the movement and sto ...
; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity *Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or ''vice versa''); see
Discounts and allowances Discounts and allowances are reductions to a basic price of goods or services. They can occur anywhere in the distribution channel, modifying either the manufacturer's list price (determined by the manufacturer and often printed on the package ...
. *Short-term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank
loan In finance, a loan is the lending of money by one or more individuals, organizations, or other entities to other individuals, organizations, etc. The recipient (i.e., the borrower) incurs a debt and is usually liable to pay interest on that de ...
(or overdraft), or to "convert debtors to cash" through " factoring".

*
Cash conversion cycle In management accounting, the Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. It is thus a measure of the liquidity risk entailed by grow ...
* Overtrading * Quick ratio analysis * Sustainable growth rate *
Trade finance Trade finance is a phrase used to describe different strategies that are employed to make international trade easier. It signifies financing for trade, and it concerns both domestic and international trade transactions. A trade transaction require ...
* Working capital management