BUS103: Introduction to Financial Accounting

Working capital is a financial metric which represents operating liquidity available to a business, organization and other entity.

Learning Objective

• Discuss why working capital is an important metric for businesses.

Key Points

• Net working capital is calculated as current assets minus current liabilities.
• Current assets and current liabilities include three accounts which are of special importance: accounts receivable, accounts payable and inventories.
• 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. The management of working capital involves managing inventories, accounts receivable and payable, and cash.
  

Terms

• operating liquidity
  The ability of a company or individual to quickly convert assets to cash for the purpose of paying operating expenses.
• deficit
  the amount by which spending exceeds revenue
  

Working capital (abbreviated WC) is a financial metric which represents operating liquidity available to a business, organization or other entity, including a governmental entity. Along with fixed assets, such as plant and equipment, working capital is considered a part of operating capital.

Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital, that is commonly used in valuation techniques such as discounted cash flows (DCFs). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. An increase in 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.

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact: accounts receivable (current asset), inventories (current assets), and accounts payable (current liability). 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.

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. 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. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Inventory management is to 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.

Debtors' management involves identifying the appropriate credit policies, 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.

Short-term financing requires identifying 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).

Cash management involves identifying the cash balance which allows for the business to meet day-to-day expenses, but reduces cash holding costs.

Statement of cash flows
The management of working capital involves managing inventories, accounts receivable and payable, and cash.