Working Capital and its Importance.
A profitable company is one, which has more assets, compared to liabilities. Assets may include the company’s property, inventory and liquid cash. On the other hand, taxes, rent, utilities such as water and electricity, and wages that are yet to be paid are termed as liabilities. Now, let’s learn more about Working Capital
The difference between current assets and liabilities is known as working capital. It is the measure of a company’s financial health and is the amount that can be used for regular operations and investments. To determine where a company stands, its working capital ratio should be calculated.
The formula is as follows:
Current assets/ Current liabilities = Working capital ratio
Suppose a startup has 100,000 in current assets and 50,000 in current liabilities. This means that the working capital is 100,000/50,000. Therefore, the ratio is 2:1. This is a fairly healthy ratio and it can allow for taking advantage of future opportunities and in paying off short-term debt. If short obligations are not fulfilled, the startup or any business for that matter may face bankruptcy and holding excessive liquid cash may not be the best use of resources.
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The components of working capital:
- Inventory: Refers to the products/stock a company owns and plans to use before its depreciation. However, not all of this inventory is ready for customer use. Raw materials or commonly known as commodities, such as metal, cotton, silicon and so on that are manufactured further ( but not completely) are known as stock that is still in progress. Whereas finished products such as clothes, mobile phones, and so on are ready for customer use and can be sold right away.
Exessive inventory may lead to problems, as it requires more storage expenses and may lead to wastage. But how do companies know if there is excessive inventory in possession? Simple! Just use the formula to calculate the working capital ratio; Inventory/working capital. This is also one way to understand the amount of cash that can be raised using working capital; If a company has a large working ratio, it may be difficult to convert working capital to cash by direct means.
2. Accounts receivable: In a few scenarios, customers purchase a product and are yet to pay their bill through their bank account, or other debtors still need some time to pay off what they owe. To combat this, companies must collect their receivables as soon as possible, and it must be calculated well because it is prone to manipulation. Many small business owners spend a lot of time and energy chasing debtors and making them pay.
3. Accounts payable: Essentially refers to the money owed by a company to its suppliers/creditors, and is a liability on company balance sheets. It requires tremendous attention to detail, accuracy, strong management skills, problem-solving and communication skills to execute appropriately. It is also critical in managing a company’s cash flow and it also appears on cash flow statements.
4. Min-max plan: Ensures the amount of inventory that needs to be kept according to its usefulness and safety margin. This plan also aims to eliminate the problem of overstocking and aid in the management of depreciation, so that it does not affect the working capital.
Working capital acts as the lungs of a company, helping it breathe, i.e, keeping alive and working. Each component is crucial for the day to day functioning and plays an important role for smooth sailing and capturing opportunities as they come.
What is working capital?
Working capital is the amount of available capital that a company can readily use for day-to-day operations.
Why is working capital important?
Working capital is important as it serves as a metric for how efficiently a company is operating and how stable it is in the short-term
What are the components of working capital?
The components of working capital are:
2. Accounts receivable
3. Accounts payable