Working capital management is a business strategy that ensures a company uses its current assets and liabilities as efficiently as possible. Let us understand what is working capital definition with examples, formula and management for it.
Working capital management is a business strategy that enables organizations to make the best use of their current assets while preserving enough cash flow to meet their immediate obligations. By effectively managing working capital, businesses can free up cash that would otherwise be restricted to their balance sheets. They might then be able to carry out R&D while lowering their reliance on external borrowing, finance business expansion, finance mergers and acquisitions, or finance other activities.
Definition of Working Capital
Working capital means capital required to a business for its day to day operational. Working capital is to measure a company’s current financial health. Working capital is one type reflection of company’s efficiency. Amongst every other thing an investor analyses, working capital is surely one of them.
Money owed by customers or money utilized in inventory is almost negligible because that cannot be used to pay for company’s obligations. If this is the case and problem of slow collection arises, then the company might face some problem in its operations.
What is Working Capital Management?
Working capital management means managing the working capital. Working capital management looks how the firm manages between assets as well as liabilities in short term. Every firm has short-term assets and short-term liabilities, they are also known as current assets and liabilities. It is calculated by subtracting short-term liabilities from short-term assets. The working capital ratio determines if the firm is financially stable, and has enough short-term assets to cover its short-term debts.
For determining working capital, an organization will choose current assets and subtract current liabilities. Whereas working capital ratio is, calculate by dividing current assets over current liabilities. Working capital ratio assist in determining working capital efficiency. This particular ratio is an important indicator to measure company’s financial wellness. If the ratio is less than 1.0, it implies that working capital is negative. In addition, if the ratio is more than 2.0 then the company is not investing in excess assets. Experts are of the view that ratio ranging 1.2 – 2.0 is sufficient.
To understand what working capital management is we need to know the case scenarios where it is needed. Let us say a company’s short term assets are less than its short-term liabilities, which means that it does not have enough assets to cover its debts. This may lead to bankruptcy. A declining working capital ratio over a longer time of period could also be a red flag that warrants further analysis.
Working Capital Formula
Working capital is cash available for the day-to-day business operations for a company.
Formula for working capital is: Current Assets – Current Liabilities.
Working Capital Example
It could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller. From the below balance sheet we can calculate working capital of ABC company.
When applying working capital formula, we get 23,450 (73,900 – 50,450) from the below balance sheet. From this example of working capital we can say that ABC company has 23,450 available cash for their daily business operations.
Formula for Working Capital Ratio
To calculate working capital ratio formula is: Current Assets / Current Liabilities.
Working Capital Management Example
From the management prospect, working capital ratio determines the efficiency of a company. Let us take a below balance sheet to evaluate as a example of working capital management of ABC company.
When applying working capital ratio formula, we get ratio as 1.46 (73,900 / 50,450). From this example of working capital ratio we can conclude that ratio is between 1.2 to 2.0 which is good. Hence there is sufficient cash available for working capital management.
So by now you know that working capital management is a managerial accounting strategy that aims to optimize higher ROI (return on investment) and minimize cost of capital. During any financial crisis, the accounting team focuses on enhancing the company’s working capital management to normalize day to day business activity.
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