Working Capital: Definition
The term working capital refers to the portion of total capital that is used to run a business efficiently and regularly. It is also known as short-term capital, circulating capital, or liquid capital.
Working Capital: Explanation
It also means management of current liabilities, including sundry creditors, bills payable, outstanding creditors, bank overdraft, and so on.
A company’s working capital is its total current assets minus its current liabilities.
The problem of working capital management involves the problem of decision-making regarding investment in current assets with an objective of maintaining liquidity of funds to enable the firm to meet its payment obligations as and when due.
Scholarly Definitions of Working Capital
Noteworthy definitions of working capital published by previous authors and researchers are:
- Need Molottand Field: “Working capital means current assets.”
- J.S. Mill: “The sum of the current assets is the working capital of a business.”
- C.W. Gutenberg: “Working capital … is the excess of current assets over current liabilities.”
- Bonneville and Dewey: “Any acquisition of funds that increases the current assets increases working capital.”
Why Do Firms Need Working Capital?
The basic objectives for which a business unit needs working capital are:
- To acquire fixed assets that are financed through long-term sources
- For current requirements or for acquiring current assets, which is partly raised from long-term funds and partly from short-term funds
The management of working capital is useful for day-to-day finance for a business. Proper cash management is needed for every unit. Without this, the business will experience many problems, including the lack of cash to pay creditors and suppliers.
Working capital is needed to make payments for the day-to-day expenses of the organization, as well as to cover the organization’s financial requirement between the gap period of production to sales.
Working capital is also essential for maintaining the liquidity of the organization.
Formula For Working Capital
The following formula is used to calculate working capital:
Working capital = Current assets – Current liabilities
Challenges When Managing Working Capital
To manage working capital effectively, it is necessary to overcome the following challenges:
- To decide on the optimum level of investment in various current assets
- To solve the problem of the capital mix (i.e., the optimal ratio of short-term and long-term funds)
- To arrange an appropriate means of short-term financing
Objectives, Needs, and Importance of Working Capital
2. Safety to Creditors: Management will face less pressure if they have sufficient working capital because they can pay creditors on the due date, which increases the creditability of the firm.
3. Debt-Securing Capacity: When firms pay their creditors, their creditability increases, which elevates their capacity to raise funds from the market. As such, the firm can use purchase goods on credit and borrow short-term funds from the bank.
4. High Dividend Rate: When a firm has adequate resources, it can pay a high rate of dividends to shareholders. Projects are retained in business so that when the need for additional financing arises, the same can be applied.
Techniques/Methods of Calculating Working Capital
The following are the important techniques/methods of calculating working capital:
- Operating cycle method
- Working capital method
- Cash forecasting method
- Projected balance sheet method
- P & L Adj. method
Working Capital Cycle
The working capital cycle is the period that a business takes to convert cash that has been invested in goods back into cash. A business unit buys goods and keeps them for a period before they are sold (i.e., average stock retention period).
After the finished goods are sold (frequently on credit), debtors take some time to pay for them (Average credit allowed period).
The total time taken to achieve any of the following tasks represents the period taken by a business to collect its revenue from the point of purchasing raw materials to the point of receiving cash from debtors:
- Convert raw materials into work-in-progress (i.e., average stock retention period for raw materials)
- Convert work-in-progress into finished goods (i.e., average stock retention period for WIP)
- Convert finished goods into debtors (i.e., average stock retention period for finished goods)
- Convert debtors into cash (i.e., average credit allowed period)
However, since businesses also receive credit from suppliers (i.e., average credit received period), the actual period for which it funds its working capital is determined as follows:
Working Capital as a Percentage of Capital Employed
This indicator shows what portion of the total capital employed is held in the form of working capital.
Clearly, a trading concern would have a larger portion of its capital employed in the form of working capital, while a manufacturing company would not.
However, often the best indicator of a suitable division of capital employed between fixed assets and working capital is provided by the industry average.
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.