What Is Working Capital?
Working capital refers to the financial resources available to sustain a business’s ongoing operations. It measures the funds readily accessible for immediate needs such as payroll, planned and unplanned expenses, and purchases of essential materials. A robust working capital level reflects a well-managed, efficient business capable of meeting daily operational demands.
How Is Working Capital Calculated?
Working capital is calculated by considering only current assets—those that can be liquidated within a year or less. These assets include cash, accounts receivable, inventory, cash equivalents in checking and savings accounts, prepaid expenses, and raw materials. Current liabilities, which are obligations payable within a year, must also be considered. These liabilities encompass accounts payable, wages, dividends, short-term debt, lease payments, and income taxes.
The formula for calculating working capital is:
Working Capital = Current Assets – Current Liabilities
Due to this formula, working capital is also known as net working capital.
Working Capital Calculation Example
Consider a company with current assets totaling ₹10 crore and current liabilities amounting to ₹7 crore. The working capital is calculated as follows:
Working Capital = ₹10,00,00,000 (assets) – ₹7,00,00,000 (liabilities) = ₹3,00,00,000
This indicates the business has ₹3 crore in assets that can be readily converted to cash for short-term needs
Working Capital Ratio
The working capital ratio is calculated by dividing current assets by current liabilities. This ratio serves as an indicator of the business’s financial health.
For instance:
- A ratio less than one suggests high current liabilities relative to current assets, indicating potential financial strain.
- A ratio greater than one indicates more current assets compared to current liabilities, reflecting better financial health.
- A ratio of two or more may suggest excess current assets, implying potential for investment in future growth.
An ideal working capital ratio lies between one and two.
How Is Working Capital Used by a Business?
Businesses require working capital to meet ongoing needs, especially during revenue fluctuation cycles. For example, a toy company may have most sales during the Christmas season but needs sufficient working capital to operate year-round, paying salaries and making purchases even during off-peak periods. Working capital allows the business to meet these obligations and prepare for peak seasons.
Additionally, working capital can be invested in future growth, helping businesses stay competitive. Investments in inventory, machinery, equipment, or software enable businesses to anticipate future needs and expand appropriately.
