# Working capital

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Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organisation or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. [1] If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

In accounting, liquidity is a measure of the ability of a debtor to pay their debts as and when they fall due. It is usually expressed as a ratio or a percentage of current liabilities. Liquidity is the ability to pay short-term obligations.

## Contents

A company can be endowed with assets and profitability but may fall short of liquidity if its assets cannot be readily converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Profit, in accounting, is an income distributed to the owner in a profitable market production process (business). Profit is a measure of profitability which is the owner’s major interest in income formation process of market production. There are several profit measures in common use.

As money became a commodity, the money market became a component of the financial market for assets involved in short-term borrowing, lending, buying and selling with original maturities of one year or less. Trading in money markets is done over the counter and is wholesale.

## Calculation

Working capital is the difference between current assets and current liabilities. It is not to be confused with trade working capital (the latter excluding cash).

The basic calculation of working capital is based on the entity’s gross current assets.

${\displaystyle {\text{Working Capital}}={\text{CURRENT ASSETS}}-{\text{CURRENT LIABILITIES}}}$

### Inputs

Current assets and current liabilities include four accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

Cash and cash equivalents (CCE) are the most liquid current assets found on a business's balance sheet. Cash equivalents are short-term commitments "with temporarily idle cash and easily convertible into a known cash amount". An investment normally counts to be a cash equivalent when it has a short maturity period of 90 days or less, and can be included in the cash and cash equivalents balance from the date of acquisition when it carries an insignificant risk of changes in the asset value; with more than 90 days maturity, the asset is not considered as cash and cash equivalents. Equity investments mostly are excluded from cash equivalents, unless they are essentially cash equivalents, for instance, if the preferred shares acquired within a short maturity period and with specified recovery date.

Accounts receivable is a legally enforceable claim for payment held by a business for goods supplied and/or services rendered that customers/clients have ordered but not paid for. These are generally in the form of invoices raised by a business and delivered to the customer for payment within an agreed time frame. Accounts receivable is shown in a balance sheet as an asset. It is one of a series of accounting transactions dealing with the billing of a customer for goods and services that the customer has ordered. These may be distinguished from notes receivable, which are debts created through formal legal instruments called promissory notes.

Inventory or stock is the goods and materials that a business holds for the ultimate goal of resale.

The current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

Debt is when something, usually money, is owed by one party, the borrower or debtor, to a second party, the lender or creditor. Debt is a deferred payment, or series of payments, that is owed in the future, which is what differentiates it from an immediate purchase. The debt may be owed by sovereign state or country, local government, company, or an individual. Commercial debt is generally subject to contractual terms regarding the amount and timing of repayments of principal and interest. Loans, bonds, notes, and mortgages are all types of debt. The term can also be used metaphorically to cover moral obligations and other interactions not based on economic value. For example, in Western cultures, a person who has been helped by a second person is sometimes said to owe a "debt of gratitude" to the second person.

An increase in net working capital indicates that the business has either increased current assets (that it has increased its receivables or other current assets) or has decreased current liabilities—for example has paid off some short-term creditors, or a combination of both.

## Working capital cycle

### Definition

Working capital is computed as the sum of: Inventories (+) Trade receivable (+) Cash (-) Trade payables. Working capital cycle (WCC), also known as cash conversion cycle, is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. Under certain conditions, minimizing working capital might adversely affect the companies' ability to realize profitability, e.g. when unforeseen hikes in demand exceed inventories, or when a shortfall in cash restricts the companies ability to acquire trade or production inputs.

### Meaning

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30-day cycle usually needs to be funded through a bank operating line, and the interest on this financing is a carrying cost that reduces the company's profitability. Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow. Sophisticated buyers review closely a target's working capital cycle because it provides them with an idea of the management's effectiveness at managing their balance sheet and generating free cash flows.

In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, and convertible security holders when they want to see how much cash can be extracted from a company without causing issues to its operations.

As an absolute rule of funders, each of them wants to see a positive working capital. Such situation gives them the possibility to think that your company has more than enough current assets to cover financial obligations. Though, the same can’t be said about the negative working capital. [2] A large number of funders believe that businesses can’t be sustainable with a negative working capital, which is a wrong way of thinking. In order to run a sustainable business with a negative working capital, it’s essential to understand some key components.

1. Approach your suppliers and persuade them to let you purchase the inventory on 1-2 month credit terms, but keep in mind that you must sell the purchased goods, to consumers, for money. 2. Effectively monitor your inventory management, make sure that it’s often refilled and with the help of your supplier, back up your warehouse.

Plus, big companies like McDonald’s, Amazon, Dell, General Electric and Wal-Mart are using negative working capital. [ citation needed ]

## Working capital management

Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets, and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

### Decision criteria

By definition, working capital management entails short-term decisions—generally, relating to the next one-year period—which are "reversible". These decisions are therefore not taken on the same basis as capital-investment decisions (NPV or related, as above); rather, they will be based on cash flows, or profitability, or both.

• One measure of cash flow is provided by the cash conversion cycle—the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count.
• In this context, the most useful measure of profitability is return on capital (ROC). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed; return on equity (ROE) shows this result for the firm's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working-capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short-term policy with long-term decision making. See economic value added (EVA).
• Credit policy of the firm: Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash conversion cycle.

### Management of working capital

Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.

• Cash management . Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs.
• Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials—and minimizes reordering costs—and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the Finished Goods should be kept on as low level as possible to avoid overproduction—see Supply chain management; Just In Time (JIT); Economic order quantity (EOQ); Economic quantity
• Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); see Discounts and allowances.
• Short-term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft), or to "convert debtors to cash" through "factoring".

## Related Research Articles

In financial accounting, a balance sheet or statement of financial position or statement of financial condition is a summary of the financial balances of an individual or organization, whether it be a sole proprietorship, a business partnership, a corporation, private limited company or other organization such as Government or not-for-profit entity. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A balance sheet is often described as a "snapshot of a company's financial condition". Of the four basic financial statements, the balance sheet is the only statement which applies to a single point in time of a business' calendar year.

In double entry bookkeeping, debits and credits are entries made in account ledgers to record changes in value resulting from business transactions. Generally speaking, if cash is spent in a business transaction, the cash account is credited, and conversely, when cash is obtained in a business transaction, it is described as a debit. Debits and Credits can occur in any account. For simplicity it is often best to view Debits as positive numbers and Credits as negative numbers. When all the debits and credits that are transacted in each account are added up the resulting account total could be a net Debit or a net Credit. If the total of the account is in a net Debit position (positive), it is generally classified in the Asset section of the balance sheet, whereas accounts that total to a net Credit (negative) are shown in the liability section of the balance sheet. Accounts that relate to the company's profit are totaled to yield company earnings and are classified in the Equity section of the balance sheet. When recording incoming cash (revenue) a Debit will be made to Cash or equivalent Assets and a Credit will be made on the revenue account in the income statement. If a company has a positive Net Income, the Retained Earnings will receive a Credit when closing out the Income Statement for the year, while a Net Loss will result in a Debit to the Retained Earnings. A net Credit (negative) balance in Retained Earnings in the Equity Section demonstrates that the company has been profitable over time, whereas a Debit (positive) balance in the Equity section, would demonstrate that the company has been unprofitable. In most companies the following accounts end-up in Credit positions: accounts payable, share capital, loans payable; while Debit accounts typically include Equipment, Inventory, Accounts Receivable. Debits must equal Credits (negatives) in each transaction; individual transactions may require multiple debit and credit entries.

In management accounting, the Cash conversion cycle (CCC) measures how long a firm will be deprived of cash if it increases its investment in inventory in order to expand customer sales. It is thus a measure of the liquidity risk entailed by growth. However, shortening the CCC creates its own risks: while a firm could even achieve a negative CCC by collecting from customers before paying suppliers, a policy of strict collections and tax payments is not always sustainable.

Factoring is a financial transaction and a type of debtor finance in which a business sells its accounts receivable to a third party at a discount. A business will sometimes factor its receivable assets to meet its present and immediate cash needs. Forfaiting is a factoring arrangement used in international trade finance by exporters who wish to sell their receivables to a forfaiter. Factoring is commonly referred to as accounts receivable factoring, invoice factoring, and sometimes accounts receivable financing. Accounts receivable financing is a term more accurately used to describe a form of asset based lending against accounts receivable. The Commercial Finance Association is the leading trade association of the asset-based lending and factoring industries.

Financial accounting is the field of accounting concerned with the summary, analysis and reporting of financial transactions related to a business. This involves the preparation of financial statements available for public use. Stockholders, suppliers, banks, employees, government agencies, business owners, and other stakeholders are examples of people interested in receiving such information for decision making purposes.

In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7, is the International Accounting Standard that deals with cash flow statements.

In accountancy, days sales outstanding is a calculation used by a company to estimate the size of their outstanding accounts receivable. It measures this size not in units of currency, but in average sales days.

Treasury services is a function of an investment bank which provides transaction, investment, and information services for chief financial officers or treasurers. Treasury services concentrates and invests client money, and provides trade finance and logistics solutions as well as safeguards, values, clears and services securities and portfolios for investors and broker-dealers. Treasury Services is a transaction intensive and system intensive business. This is a source of risk free fees income for the banks.

In financial accounting, operating cash flow (OCF), cash flow provided by operations, cash flow from operating activities (CFO) or free cash flow from operations (FCFO), refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities. The International Financial Reporting Standards defines operating cash flow as cash generated from operations less taxation and interest paid, investment income received and less dividends paid gives rise to operating cash flows. To calculate cash generated from operations, one must calculate cash generated from customers and cash paid to suppliers. The difference between the two reflects cash generated from operations.

In finance, the quick ratio, also known as the acid-test ratio is a type of liquidity ratio which measures the ability of a company to use its near cash or quick assets to extinguish or retire its current liabilities immediately. Quick assets include those current assets that presumably can be quickly converted to cash at close to their book values. It is the ratio between quickly available or liquid assets and current liabilities.

Financial statement analysis is the process of reviewing and analyzing a company's financial statements to make better economic decisions to earn income in future. These statements include the income statement, balance sheet, statement of cash flows, notes to accounts and a statement of changes in equity. Financial statement analysis is a method or process involving specific techniques for evaluating risks, performance, financial health, and future prospects of an organization.

Initially pioneered by financial institutions during the 1970s as interest rates became increasingly volatile, asset and liability management is the practice of managing risks that arise due to mismatches between the assets and liabilities.

Profitable Growth is the combination of profitability and growth, more precisely the combination of Economic Profitability and Growth of Free cash flows. Profitable growth is aimed at seducing the financial community; it emerged in the early 80’s when shareholder value creation became firms’ main objective.

Financial management focuses on ratios, equities and debts. It is useful for portfolio management,distribution of dividend,capital raising,hedging and looking after fluctuations in foreign currency and product cycles.Financial managers are the people who will do research and based on the research, decide what sort of capital to obtain in order to fund the company's assets as well as maximizing the value of the firm for all the stakeholders. It also refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. The significance of this function is not seen in the 'Line' but also in the capacity of the 'Staff' in overall of a company. It has been defined differently by different experts in the field.

In financial accounting, an asset is any resource owned by the business. Anything tangible or intangible that can be owned or controlled to produce value and that is held by a company to produce positive economic value is an asset. Simply stated, assets represent value of ownership that can be converted into cash. The balance sheet of a firm records the monetary value of the assets owned by that firm. It covers money and other valuables belonging to an individual or to a business.

Strategic financial management is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference.

A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.

Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).

Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.

## References

1. "Negative Working Capital: Definition & Examples". Inevitable Steps. August 18, 2015. Retrieved February 21, 2016.