What is Working Capital and Its Formula | Motilal Oswal

What is Working Capital and Its Formula

Working capital is also known as net working capital or NWC. This is a commonly used metric when investors want to gauge the health of any company they may think of investing in. Specially used to measure the short-term health of a company, working capital lets investors know how a company is positioned should they consider its investment. Say, if you are an investor and wish to invest in a particular organization’s stock, you may want an answer to the question, “What is working capital?”. 

What is working capital

To put it simply, working capital represents the difference between the current assets of an organization and the current liabilities of the organization. The current assets reflect things like cash, customers’ or clients’ unpaid bills/accounts receivable, and inventories of finished products and raw materials. Current liabilities include debts and accounts payable.

It is important to note that in the world of corporate finance, “current” refers to a one-year, or less, timeframe. Therefore, current assets may be available within a year, and current liabilities may be due within a year.  

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Understanding Working Capital

Working capital can best be understood by investors and companies themselves when they offset debts with assets. To understand working capital meaning, estimates of working capital are derived from the range of assets and liabilities on a balance sheet of any company. By simply viewing the most liquid assets against immediate debts, companies are better able to grasp the kind of liquidity they have access to shortly. 

Working capital could also be said to be a measure that estimates a company’s efficiency in operations concerning its financial health in the short term. If any company displays a significant positive net working capital, then it may have the potential to invest in measures towards expansion and growth. In case a company’s current assets are not more than its current liabilities, then the company may experience trouble where growth is concerned or have difficulty in paying creditors back. The company could even face bankruptcy in the worst circumstances. 

How much working capital is needed?

The amount of working capital that is required by a company depends largely on the industry in that a company is engaged in. A working capital formula to determine working capital may be used to find out how much-working capital an organization requires, or has at its disposal. However, before that is explained, it should be noted that some sectors have longer cycles of production and may require a higher degree of working capital. Such companies may not have the rapid inventory turnover that generates cash on demand. Contrastingly, retail companies interacting with a huge amount of customers on a daily basis can frequently raise funds for the short term much faster. These companies will, typically, have lower working capital needs. 

The Working Capital Formula

Once you know what working capital is all about in relation to current assets and current liabilities, the formula to calculate working capital is easy to grasp. In order to calculate working capital with the formula, you must subtract a company’s current liabilities from a company’s current assets. The figures that reflect both current liabilities and current assets are found in the financial statements of public companies. These are publicly disclosed on websites of the companies and on other portals and are easy to access. 

To translate the formula into an equation, we get:

Working Capital = Current Assets - Current Liabilities

For instance, say an organization has Rs. 1,00,000 of current assets and Rs. 20,000 of current liabilities. The company has Rs. 80,000 of working capital. What does this mean for the company? This brings us to the first question - What is working capital? In the example mentioned, working capital is Rs. 80,000, the amount the company has at its disposal for short-term use. This is a handy sum if the company needs to fulfil certain payment obligations in the near future or present time. 

When the working capital signals a positive result, this means that a company’s assets exceed its liabilities. The company obviously has more than enough resources which would cover its debt in the short term. In such cases, companies have residual cash if all the current assets are liquidated to pay off debts. 

If a working capital result is in negative, the company does not have enough assets to cover its current liabilities. Therefore, the company may have more short-term debt than short-term resources. This is an indicator that the company has poor financial health for the short term, a low degree of liquidity, and potential issues with paying off debt obligations as and when they may be due. 

Invest with Information

Being well-informed in advance is the key to sound financial investment. When investors go ahead and open a demat account to invest in company stock, thorough research must be done to find out about a company and its fundamentals. Working capital is one measure that can be used to evaluate a company, and this is true if you want to find out about a company that is about to float an upcoming IPO as well. 

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