Working capital is a term used in business to describe the number of assets a company has, plus the amount of debt it has, minus its liabilities. It is also called liquidity, as it acts as a liquid asset for companies. The higher the working capital Mississauga or its liquidity position, the more profitable and efficient it can be.
What Is Working Capital?
The formula for calculating working capital:
Current Assets – Current Liabilities = Working Capital or Liquidity
Current assets refer to all the assets likely to be converted into cash (or quickly realized) during the next 12 months. These include cash, short-term investments, accounts receivables, inventory, and prepaid expenses. Current liabilities refer to all the obligations that will need to be paid within one year. These include accounts payable, short-term debt, and long-term debt. Suppose a company has $500 in cash and $1,000 in accounts receivable, then the company’s working capital is $500-$1,000=-$500
Why Is Working Capital Important?
Working capital or liquidity is essential for any business because it is used to pay for business operations and provide funds for growth. Suppose a company does not have enough working capital available for operations. In that case, it may borrow money from another source and pay interest. A company operating with insufficient working capital cannot support its business operations. It must start laying off employees or cutting back on production. With inadequate working capital, a company must also look outside the business for funding to help pay debt obligations.
What Is the Relationship Between Working Capital and Profitability?
Working capital or liquidity is one of the four critical components of profitability in business. It is necessary for every business because it pays for operations and functions as the source of capital for growth and financing.
Working Capital and Cash Flow
Company cash flow is inversely linked with working capital. This means that as a company’s working capital increases, its ability to produce cash decreases. Companies usually need to replace the current working capital with fresh capital, which will allow the company to expand or make improvements within the business.
Working Capital and Financial Leverage
The working capital and financial leverage are directly related. Working capital can be used as a source of financing for the company. This will result in a company’s assets becoming part of the liabilities because the company borrows money to invest in assets that provide capital. The amount borrowed is added to the current assets on the balance sheet. It becomes a long-term liability when repayment begins. Another way this is done is by using equity (stock) instead of borrowing money from banks or other lending institutions.
Working Capital and Return on Assets
As a company increases its working capital and decreases the value of its financial assets, its return on assets or profitability will also decrease. This is because new assets are added to the balance sheet even though these assets may be worthless at the time. For example, putting bad inventory on a balance sheet increases the amount of cash used to make payments. A new asset is created even though it is worthless and will be written off in future years. This decreases profitability for a company because the company does not realize the value of the cash and assets on the balance sheets.
Working Capital and Return on Equity
The relationship between return on equity and working capital is found in the book value of a company. Working capital turns into equity as it is invested in assets and liabilities. If a business has negative equity, it means that its liabilities exceed its assets. This means that working capital has been turned into equity with no return on investment.
How to Increase Working Capital
There are three ways to increase working capital. They include:
- Increase the Current Ratio
A company can increase its current ratio by decreasing its current liabilities and increasing its current assets. This is usually done by increasing sales and reducing expenses. The company can also pay down or pay off a debt to reduce current liabilities. The best way to do this is with cash flow from operations rather than loans or bonds.
- Increase the Net Working Capital Ratio
A company can increase its net working capital ratio by reducing expenses and increasing cash flow from operations. This is usually done by increasing sales and cutting expenses. The best answer is using the cash flow from operations to pay down or pay off existing debt.
- Acquire a Business That Has a Higher Working Capital Position Than You Do
This is an excellent way to expand your business and reduce the amount of capital you need to start new projects or begin operations.
Get the Financial Boost You Need
Working capital is an essential factor for any business. If a company has low working capital, a company must find the money elsewhere. It may borrow it from a bank or other lenders or sell it to investors as stock in the company.