Definition

Working capital is the money a business uses for its daily operations. It's calculated by subtracting current liabilities from current assets.

Working Capital = Current Assets - Current Liabilities

Describe

A company's working capital is its vitality. It is the money that a business uses to finance its regular activities, such as paying staff, buying products, and making short-term debt payments. It basically serves as a gauge for a company's liquidity and capacity to pay bills on time.

Factors affecting working capital
 

At time, few factors can affect the working capital:

Business Size and Growth

Larger companies usually need more working capital to fund their operations since they incur higher costs and hold larger inventory. Working capital may be strained by rapid growth when assets such as inventories, accounts receivable, and other investments expand more quickly than income.

Industry and Operating Cycle

Because producing things takes time and money, industries with extended production cycles (like manufacturing) sometimes have greater working capital requirements. Seasonally fluctuating businesses need different amounts of working capital at different times of the year.

Credit Policy

Offering consumers lenient credit terms might result in increased accounts receivable, which can tie up cash and increase the requirement for working capital.Tighter credit guidelines might increase cash flow by speeding up the collecting process.

Inventory Management

Having too much inventory raises the cost of storage and requires a large working capital investment. Reducing the amount of capital locked up in stock is one way that effective inventory management contributes to working capital optimization.

Economic Conditions

Costs can go up and working capital's purchasing power can go down due to inflation. Reduced cash flow, a rise in bad debts, and slower sales are all possible outcomes of economic downturns. Economic expansions can enhance revenue and profitability, but they also raise the need for working capital to maintain growth.

How to calculate working capital?
 

This is how you can calculate the working capital:

Step 1: Identify Current Assets

Start by gathering all assets that can be converted into cash within a year. Do not forget to include cash, accounts receivable, inventory, and prepaid expenses.

Step 2: Identify Current Liabilities

Then list all the debts and obligations due within a year. You must include accounts payable, short-term loans, accrued expenses, and taxes payable.

Step 3: Calculate Total Current Assets

After you have identified all the current assets in step 1, add up all the current assets.

Step 4: Calculate Total Current Liabilities

After calculating total current assets, you can now add all current liabilities you identified in step 2.

Step 5: Subtract Current Liabilities from Current Assets

After you have calculated, current assets and current liabilities, follow these steps:

• Working Capital = Current Assets - Current Liabilities
• The result is your company's working capital.

Trends that affect the working capital

Some of the trends that affect the working capital include:

• Disruptions to the global supply chain have resulted in higher inventory levels, longer payment terms, and variable costs, all of which have an effect on working capital management.
• Digital Transformation: Although the move to digital operations can cut costs and increase efficiency, working capital may be initially strained by initial technological investments.
• Economic Volatility: A company's cash flow and working capital requirements can be greatly impacted by changes in inflation, interest rates, and consumer spending trends.
• Sustainability Focus: The availability of operating capital may be impacted by the increased expenditures and investments associated with environmental and social responsibility.

Example

Walmart is a prime example of a company that excels in working capital management.

The brand is renowned for its efficient inventory management. By maintaining a rapid inventory turnover, they minimise the amount of capital tied up in stock.  

The company leverages its size to negotiate favourable payment terms with suppliers, extending its payment cycle and conserving cash.  

Walmart has optimised its cash conversion cycle by selling products quickly, collecting payments promptly, and delaying payments to suppliers.

FAQ

Give me types of working capital?

Some of the types of working capital are:

• Net working capital: Current assets minus current liabilities.  
• Permanent working capital: Minimum assets needed for daily operations.
• Temporary working capital: Extra assets needed for seasonal or unexpected needs.  
• Negative working capital: Liabilities exceed assets (short-term liquidity issue).

Difference between fixed capital and working capital.

Long-term assets, like property and equipment, used to start and operate a business are called fixed assets.   On the other hand, short-term assets minus short-term liabilities, used for day-to-day operations.   
 

What are the components of working capital?

Working capital is primarily composed of:

A) Current Assets:The items that can be converted into cash within one year, when in need:

• Receivables from customers (money owed)
• Stock (unfinished goods, work-in-progress, and raw materials)
• Prepaid costs (expenses that are paid for in front)

B) Current Liabilities: Liabilities that are short-term debts that must be paid within a year. Accounts payable (money owed to suppliers)  

• Short-term loans
• Accrued expenses (expenses incurred but not yet paid)  
• Taxes payable