HOME

TheInfoList




Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization, 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 Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compar ...
minus
current liabilities In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been calle ...
. 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 Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as ...
and
profitability An economic profit is the difference between the revenue a has received from its outputs and the s of its inputs. Unlike an , an economic profit takes into account both a 's and costs, whereas an accounting profit only relates to the explici ...
but may fall short of
liquidity Liquidity is a concept in economics involving the convertibility of assets and obligations. It can include: * Market liquidity In business Business is the activity of making one's living or making money by producing or buying and selling ...

liquidity
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 In financial accounting Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and co ...
(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 An in ...
(current asset) *
inventory Inventory () or stock () refers to the goods and materials that a holds for the ultimate goal of resale, production or utilisation. is a discipline primarily about specifying the shape and placement of stocked goods. It is required at differen ...
(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. Overview An accounts ...
(current liability) The current portion of
debt Debt is an obligation that requires one party, the debtor A debtor or debitor is a legal entity (legal person) that owes a debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to ...

debt
(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 Accounting or Accountancy is the measurement ' Measurement is the number, numerical quantification (science), quantification of the variable and attribute (research), attributes of an object or event, which can be used to compar ...
(that it has increased its receivables or other current assets) or has decreased
current liabilities In accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such as businesses and corporations. Accounting, which has been calle ...
—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 Corporate finance is the area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and i ...
. 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 Financial accounting is the field of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about economic entity, economic entities such a ...

balance sheet
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 Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goo ...
*
Accrual basis accountingAccrual (''accumulation'') of something is, in finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. ...
creating deferred revenue while the
cost of goods sold Cost of goods sold (COGS) is the carrying value In accounting, book value is the value of an asset according to its balance sheet account balance. For assets, the value is based on the original cost of the asset less any depreciation, amortization ...
is lower than the revenue to be generated ** E.g. a
software as a service Software as a service (SaaS ) is a software licensing A software license is a legal instrument (usually by way of contract law A contract is a legally binding agreement that defines and governs the rights and duties between or among its P ...
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: Science and technology * Surgical operation Surgery ''cheirourgikē'' (composed of χείρ, "hand", and ἔργον, "work"), via la, chirurgiae, meaning "hand work". is a medical or dental specialty that ...

operations
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 In management accounting or managerial accounting, managers use the provisions of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about ...
—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 Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and ...
(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 Equity may refer to: Finance, accounting and ownership *Equity (finance), ownership of assets that have liabilities attached to them ** Stock, eq ...
(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 Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within those societies. T ...
, 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#REDIRECT Economic value added In corporate finance, as part of fundamental analysis, economic value added is an estimate of a firm's economic profit, or the value created in excess of the Required rate of return, required return of the types of comp ...
(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 In management accounting or managerial accounting, managers use the provisions of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about ...
.


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 Economics () is a social science Social science is the Branches of science, branch of science devoted to the study of society, societies and the Social relation, relationships among individuals within those societie ...
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 normally ...
,
inventories Inventory (American English American English (AmE, AE, AmEng, USEng, en-US), sometimes called United States English or U.S. English, is the set of varieties of the English language native to the United States. Currently, American English i ...
and
debtor A debtor or debitor is a legal entity (legal person) that owes a 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 ...
s) and the short-term financing, such that cash flows and returns are acceptable. *
Cash management Cash management refers to a broad area of finance Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Sa ...
. 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 are a company's partially finished goods waiting for completion and eventual sale or the value of these items. These items are either just being fabricated or ...

Work in Process
(WIP) and similarly, the
Finished Goods Finished goods are goods In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economic ...
should be kept on as low level as possible to avoid
overproduction In economics Economics () is the social science that studies how people interact with value; in particular, the Production (economics), production, distribution (economics), distribution, and Consumption (economics), consumption of goods ...
—see
Supply chain management File:Supply and demand-stacked4.png , 400px, In an efficient supply chain agreements are aligned In commerce, supply chain management (SCM), the management of the flow of good (economics), goods and Service (economics), services, between busi ...
;
Just In Time#REDIRECT Just in Time {{Redirect category shell, 1= {{R from other capitalisation {{R from ambiguous page ...
(JIT);
Economic order quantityEconomic Order Quantity (EOQ), also known as Economic Purchase Quantity (EPQ), is the order quantity that minimizes the total holding cost In marketing, carrying cost, carrying cost of inventory or holding cost refers to the total cost of holding inv ...
(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 A price is the (usually not negative) quantity Quantity is a property that can exist as a multitude or magnitude, which illustrate discontinuity and continuity. Quantities c ...
. *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 Finance is the study of financial institutions, financial markets and how they operate within the financial system. It is concerned with the creation and management of money and investments. Savers and investors have money avai ...
(or overdraft), or to "convert debtors to cash" through " factoring".


See also

*
Cash conversion cycle In management accounting In management accounting or managerial accounting, managers use the provisions of accounting Accounting or Accountancy is the measurement, processing, and communication of financial and non financial information about ...
* Overtrading * Quick ratio analysis *
Sustainable growth rateAccording to Profit impact of marketing strategy, PIMS (profit impact of marketing strategy), an important lever of business success is growth. Among 37 variables, growth is mentioned as one of the most important variables for success: market share, ...
*
Trade finance Trade finance signifies financing for trade, and it concerns both domestic and international trade transactions. A trade transaction requires a seller of goods and services as well as a buyer. Various intermediaries such as bank A bank is a ...
*
Working capital management Corporate finance is the area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the Value investing, value of the firm to the shareholders, and the tools and analysis u ...


References


External links

* How to Calculate Working Capital
Value Based Working Capital Management

Working Capital Management and Profitability Case of Pakistani Firms

Impact of Working Capital Management on Firms’ Performance: Evidence from Non-Financial Institutions of KSE-30 index
{{Authority control Financial capital