Working Capital Formula and Limitation.pdf

Working Capital details information.

2. Working capital, also called net working
capital, represents the difference between a
company's current assets and current
liabilities.
Working capital is a measure of a
company's liquidity and short-term
financial health.


Working Capital = Current Assets –
Current Liabilities.

3. For example,
Company A has current assets (cash, accounts receivables, inventories) that total $
100,000 and current liabilities (accounts payable, short-term borrowings, accrued
liabilities) that equal $ 50,000.
Therefore, Company A’s working capital formula would be the following:
$ 100,000 - $ 50,000 = $ 50,000
What does this mean for Company A? They have $ 50,000 to help grow the company.

4. Types of working capital :

When it comes to working capital, there are 8 different types:
1.Gross working capital
2. Net Working Capital
3. Permanent working capital
4. Temporary working capital
5. Regular working capital
6. Reserve Margin working capital
7. Seasonal working capital
8. Special working capital

5. Working capital cycle :

The working capital cycle, also known as the “cash conversion cycle,” is
the amount of time it takes a business to turn net working capital into actual
cash. The longer the cycle, the longer a company is tying up capital without
a return on investment.
The goal is to collect receivables as quickly as possible or by stretching the
accounts payable.
Use this formula to calculate the working capital cycle:
Working Capital Cycle = Inventory Days + Receivable Days – Payable
Days.

7. Limitations of Working Capital

Working capital can be very insightful to determine a company's short-term health. However,
there are some downsides to the calculation that make the metric sometimes misleading.
First, working capital is always changing. If a company is fully operating, it's likely that
several—if not most—current asset and current liability accounts will change. Therefore, by
the time financial information is accumulated, it's likely that the working capital position of
the company has already changed.
Working capital fails to consider the specific types of underlying accounts. For example,
imagine a company whose current assets are 100% in accounts receivable. Though the
company may have positive working capital, its financial health depends on whether its
customers will pay and whether the business can come up with short-term cash.
On a similar note, assets can quickly become devalued. Accounts receivable balances may
lose value if a top customer files for bankruptcy. Inventory is at-risk of obsolescence or theft.
Physical cash is also at risk of theft. Therefore, a company's working capital may change
simply based on forces outside of its control.
Last, working capital assumes all debt obligations are known. In mergers or very fast-paced
companies, agreements can be missed or invoices can be processed incorrectly. Working
capital relies heavily on correct accounting practices, especially surrounding internal control
and safeguarding of assets.

8. Why Is Working Capital Important?

Working capital is important because it is necessary for businesses to
remain solvent. In theory, a business could become bankrupt even if it is
profitable. After all, a business cannot rely on paper profits to pay its
bills—those bills need to be paid in cash readily in hand. Say a company
has accumulated $1 million in cash due to its previous years’ retained
earnings. If the company were to invest all $1 million at once, it could
find itself with insufficient current assets to pay for its current liabilities.

9. Is Negative Working Capital Bad?

It depends. Generally, it is bad if a company's current liabilities balance exceeds its
current asset balance. This means the company does not have enough resources in the
short-term to pay off its debts, and it must get creative in finding a way to make sure
it can pay its short-term bills on time. A short-period of negative working capital may
not be an issue depending on a company's place in its business life cycle and if it is
able to generate cash quickly to pay off debts.