Working capital – what is it?
Working capital is the difference between a company’s current assets and current liabilities. It represents the funds a company has available to finance its day-to-day operations and pay its short-term obligations, such as bills to be paid, payroll costs or current operating expenses. Working capital is one of the key indicators that assess a company’s liquidity, i.e. its ability to cover its current liabilities with current funds.
Working capital includes such current assets as inventory of goods, accounts receivable (amounts to be received from customers), cash and other resources that can be easily converted into cash in the short term. Current liabilities, on the other hand, include amounts owed to suppliers, short-term loans and other current payment obligations. The difference between these values indicates how much cash is left for the company to freely use.
Effective management of working capital is extremely important because it provides the company with liquidity, which means the ability to pay current obligations and maintain stable operations. When a company has a sufficiently high level of working capital, it is able to respond flexibly to changing market conditions, finance current needs and avoid costs associated with late payments.
Components of working capital:
- Cash resources – cash and cash equivalents that are available on hand and can be used for current financial needs.
- Accounts receivable – amounts due from customers that the company expects to receive in the short term for products or services sold. Accounts receivable management includes monitoring payment terms and enforcing timely payments.
- Inventory – goods, raw materials or products ready for sale. Effective inventory management involves keeping inventory at an optimal level – so that it is neither too high (which incurs storage costs) nor too low (which could lead to problems with order fulfillment).
- Current liabilities – short-term obligations, such as invoices from suppliers, which must be paid within a certain period of time.
Lack of sufficient working capital can lead to financial difficulties, as the company is unable to pay its obligations on time, which can negatively affect its reputation and creditworthiness. In extreme cases, a lack of liquidity can even lead to a company’s insolvency. Therefore, working capital management also includes controlling costs, effective inventory management, monitoring receivables and negotiating favorable payment terms with suppliers.
Frequently asked questions
1. How to calculate working capital?
Working capital is calculated as the difference between current assets and current liabilities. The formula is as follows: Working capital = Current assets – Current liabilities. If the result is positive, the company has more funds than its short-term debt, which means it has adequate liquidity.
2. Why is working capital important for a company?
Working capital is important because it determines a company’s ability to finance its operations and cover its short-term obligations. A high level of working capital allows a company to respond flexibly to market changes, finance inventory and avoid liquidity problems. Lack of an adequate level of working capital can lead to delays in payment, which affects the company’s reputation and creditworthiness.
3. What activities help manage working capital?
Effective working capital management includes several key activities:
- Shortening the accounts receivable cycle – encouraging customers to pay on time, for example by offering discounts for early payment.
- Effective inventory management – maintaining optimal inventory levels to avoid tying up too much money in goods and avoiding storage costs.
- Extending debt payment terms – negotiating longer payment terms with suppliers to keep more cash in the company.
- Monitoring liquidity – regularly analyzing financial indicators related to working capital in order to react early to potential problems.
