Working capital is a financial metric which represents operating liquidity of a business enterprise. It is a measure of a company’s efficiency and its short-term financial position.
Working capital is the difference between the current assets and the current liabilities.
|Working Capital = Current Assets – Current Liabilities|
Current Assets includes Accounts Receivable (Bills receivable and Sundry Debtors less provision for doubtful debts), Inventories, Cash and Cash Equivalents and Other Current Assets (excluding Loose tools, Stores and Spares and Fictitious Assets).
Current Liabilities includes Accounts Payable (Bills Payable and Sundry Creditors), Short Term Borrowings, Short Term Provisions and Other Current Liabilities.
When the Current Assets exceed the Current Liabilities (Positive Working Capital) it ensures that a firm has sufficient funds to satisfy both maturing short term debt and to carry on the day to day operations.
Negative Working Capital i.e. excess of current liabilities over current assets indicates the inability of a firm to meet its short term financial obligations. It represents working capital deficiency.
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WORKING CAPITAL MANAGEMENT
Working capital management refers to the decisions regarding the working capital. These involve managing the relationship between a firm’s short term assets and its short term liabilities in order to ensure sufficient cash flow to meet short-term debt obligations and operating expenses.
The policies and techniques for the management of working capital are:
1. Cash Management
Cash Management helps in the identification of the cash balance to allow the business to meet day to day expenses and to reduce the cash holding costs. Successful cash management prevents short term insolvency and ensures availability of sufficient funds to meet the operating expenses.
2. Inventory management
Inventory management is the overseeing and controlling of the ordering, storage and use of assets that are intended for use in the production of goods meant for sale or are finished products held for sale in the ordinary course of business.
It helps in the identification of the level of inventory which allows for uninterrupted production and at the same time reduces the investment in raw materials and minimizes the reordering costs. This helps in increasing cash flow.
3. Short Term financing
Short Term financing embraces borrowing or lending of funds for a short period of time. It is generally obtained for financing the current assets and lasts for one year or less.
Majorly all big enterprises use this as a source of finance and the current liabilities in the balance sheet indicate the uses of short term finance.
4. Working Capital Ratio
Working Capital Ratio, also known as the current ratio is an important indicator to assess the ability of the enterprise to meet its short term debts in time.
Working Capital Ratio is computed using the following formula
|Working Capital Ratio = Current Assets|
Any value of ratio below 1 is considered negative working capital and represents inadequate amount of assets whereas value of ratio between 1.2 -2.0 indicates that the company has sufficient amount of assets to cover its debts.
In an ordinary sense, working capital denotes the amount of funds needed for meeting day-to-day operations of a concern. … Hence it deals with both, assets and liabilities—in the sense of managing working capital it is the excess of current assets over current liabilities. Click on the link for a detailed understanding of the different elements of financial statement.
Unlike inventory, accounts receivable and other current assets, cash then earns a fair return and should not be included in measures of working capital