Working Capital Definition: How To Calculate Working Capital

Working Capital often called circulating capital is defined as the money used for the daily running of the business. It is the capital required for the day-to-day running of the business.

It is also the capital available to a business for general purposes after current liabilities have been cleared. Current liabilities are the liabilities which are to be settled with one year or less i.e they are liabilities that last for a short period of time. e.g: creditors, overdraft, income in advance, etc.

Working capital means the excess of current assets of a business over it's current liabilities (CURRENT ASSETS - CURRENT LIABILITIES). It includes money for paying wages, salaries and payment of raw materials used for the manufacturing of products, etc.

How Working Capital Is Valued for Accounting
On a business balance sheet, working capital includes all current assets such as cash, accounts receivable, prepaid insurances, inventory etc. These items can be quickly turned into cash, when needs arise, to clear off current expenses of the business

As stated above, net working capital is a financial measure used to exam the strength of a business. The ratio for working capital is current assets minus current liabilities . A good ratio would be 2:1; twice as much in current assets as in current liabilities. A higher current asset allows the quick sale of business assets, usually at a loss or deprecated value, to settle off current liabilities.

From an accounting perspective, net working capital is the difference between all the current assets and all the current liabilities. Current assets are those assets you can turn into cash quickly, examples are accounts receivable. Current liabilities are those bills you must paid within a short period.

Types of working capital

Categorically, there are two types of working capital, they are gross working capital and net working capital

Gross Working Capital

As the name implies, gross working capital is the total amount of money invested in the different types of current assets. It includes cash in hand, short term securities, debtors, bills receivable, prepaid expenses, inventories etc. Management should pay attention to gross working capital if they want to be thoroughly involved in the day to day running of the business.

Net Working Capital

Net working capital is the real working capital. It is the difference between the current assets and current liabilities or the excess of current assets over current liabilities.

Furthermore, Net working capital can be divided into two categories they are positives net working capital and negative net working capital. There is positive net working capital when the current assets exceed current liabilities. The negative net working capital occurs when the current liabilities exceed the current assets.

If you want to further divide working capital based on time, they can be segregated as:
Permanent Working Capital

1. Regular Working Capital
2. Reserve Working Capital

Temporary Working Capital

1. Season Working Capital
2. Special Working Capital

Features of Working Capital

1. Short Term Overview: Working Capital portrays a comprehensive view of how the company is doing in the short term if the assets are being fully utilized.
2. Liquidity: One of the key characteristics of working Capital is that it is very liquid, it can be converted to cash anytime.
3. Less Risky: Investing in current assets like working capital comes with less risk because it is just for a short period.
4. Permanency: Although it is just a kind of short term capital, a business needs working capital to stay alive forever and always.
5. Circular Flow of Cash: With working capital, their will be circular flow of cash in the entire production process from the conversion of cash to raw material, to final goods and finally back to cash again.

Changes in working capital and how it affects your finances

The impact of changes in working capital are reflected in the firm’s cash flow statement of the business, especially the operating cash flow. The operating cash flow section of the cash flow statement shows changes in its shorter-term working capital needs. A positive working capital figure means cash inflow for the period in view. In contrast, a negative working capital position means the business has spent more cash out than it brought in running its daily activities within a year. Analyzing changes in working capital can be important for any business, but it is very important to firms with seasonal or erratic cash flow needs.

Cash flow being an crucial component of financial statements, having a positive working capital has an effect on the liquidity which in turns affects your final position. A negative working capital is bad sign for your business. It shows that either the company does not have enough liquidity to pay for expenses or deteriorating revenues due to reduction in inventory and in final products.

IMPORTANCE OF WORKING CAPITAL

Working capital is very important to a business organization, as a result of this, we compiled a list of the Importance of the working capital:

1. Working capital is used to check against tying down too much money for current assets.

2. It helps to determine whether the business is solvent or not. A solvent business is a business that has the ability to settle debts without selling its fixed assets. Fixed assets are the assets that can last for a long period of time. e.g Land and Building, plant and machinery, motor van, fixtures and fittings, etc

3. Working capital also helps to determine the amount of money that will be available for the running of the day-to-day activities of the business. Some of the things needed to run the activities of the business are: repairs of equipment, fuel or gas for plant, etc.

4. Working capital is an indication that the business is financed internally and not externally or by the suppliers.

5. It is a sign that the business is healthy which help Investors to know if they will invest in the business or not.

6. Working capital is used by the business for planning in order to avoid losses.

7. It provides basis for profit making by the business since it is used to buy stock (stock are goods bought for resale) from where profit will be derived.

Example:

The financial position of David Beckham enterprises as at 31st December, 1996 is as follows:

                                  $

Cash in hand       7000

Creditors              3000

Debtors                5000

Bank overdraft    1200

Loan                     4100

Stock                    8000

You are required to find the working capital of the business.

Solution

Working capital = Current assets - Current liabilities.

Current assets = stock + debtors + cash in hand

= 8000+5000+7000 = 20000

Current liabilities = Creditors + bank overdraft + loan

= 3000+1200+4100 = 8300

Therefore, Working capital = 20000-8300 = 11,700