In order to manage your working capital in an effective manner, make timely payment to your creditors, and keep cash on hand for catering to the limited-term financing needs of business.
Working capital is a financial metric that measures a company’s liquidity and ability to repay short-term loans. It likewise determines the company’s operational efficiency. A business has to effectively manage its working capital to maintain a positive credit standing and reputation in the market.
Before I get to the part about how working capital can be calculated, it is necessary to define a pair of terms related to the determination of working capital.
Current assets are generally those assets which can be liquidated quickly. The general idea is that when you turn to the assets’ edge of the balance sheet, certain items like cash-in-hand, cash at bank, marketable securities, working inventory, etc., fall under current assets.
Moving The Discussion Forward
Current Assets: Current assets are the short term assets of a company. These are utilized within one year. Cash, accounts receivable, inventory, pre, and short term investments-paid expenses constitute the current assets of a company.
Current Liabilities: Current liabilities are the short term liabilities of a company. These are settled within one year. Accounts payable, outstanding expenses, payable taxes and short term loans constitute the current liabilities of a company.
Let’s take an illustration of a fictitious company named’ Tensa International ‘, to learn how to calculate working capital ratio. Suppose the current assets of Tensa International are USD 200, 000 and the current liabilities are USD 150, 000, then the working capital ratio for Tensa International is calculated as current assets / current liabilities, that is, USD 200, 000 / USD 150, 000, which is 1.33.
Ideally, the working capital ratio should be somewhere between 1.2 and 2.0. In case of Tensa International, the working capital ratio is 1.33. This indicates that its current liquidity position is good. However, a very high ratio, that is, above 2, indicates that the business has underutilized current assets, that is, it isn’t investing its assets properly.
On the other hand, negative working capital, that is, working capital ratio which is smaller than one, indicates that the business mightn’t be able to meet its short term liabilities. It shows that the business won’t be in a position to pay its creditors in time. A negative working ratio could also be due to reduced current assets. Negative working ratio should be analyzed very intently, as it might suggest that the sales of a company are going down and hence, accounts receivables are shrinking, thus causing a decrease in the current assets value.
Working capital management is very necessary, for maintaining an ideal ratio. Working capital management is a very important aspect of the financial administration of a company. This is because the investors base their investment decisions on a series of ratios, such as working capital ratio, debt ratios, return on equity ratios, return on investment ratio and return on assets ratio. A business should keep a number of things in mind, for managing its working capital properly. Firstly, the credit period granted to the customers shouldn’t be too long. This will see to it that the business has enough cash in hand from the realized sales. Secondly, to increase its liquidity position, the company itself should ask for longer credit period from its suppliers. Thirdly, the level of inventory maintained by a business shouldn’t be too high or too low. It should be sufficient enough to minimize the overall raw material costs. Fourthly, cash in hand and cash in bank should be managed, in a way that cash holding costs for the business are reduced to a very large extent. These measures will verify that the cash conversion cycle of a company isn’t too much and thus, the company will have enough working capital in hand at any particular time.
An appropriate working capital ratio is essential to the proper functioning of a business. A negative ratio can hamper the future investments of a company, as the investors might think that the business isn’t being run efficiently. Unavailability of enough liquid capital which presents itself in the negative working capital ratio can sometimes, lead to bankruptcy too.
Current liabilities are those liabilities that will have to pay sooner or later. The payment date for current liabilities isn’t fixed. The debt might mature anytime. So, typically, current liabilities is the total of the amount due to the creditors, bills payable, dividend, wages, etc.
I have placed current assets first in the formula as the working capital should be positive, I.e., the sum of the current assets should be greater than that of the current liabilities. It is often twice the sum of the current liabilities to mitigate any unforeseen risk factors.
Negative working capital is also helpful for a company under certain circumstances. Such companies are often better at raising cash as in relation to those with a positive working capital. Also, they’re good at generating free cash flow when the want to raise their revenues. A negative working capital is highly beneficial for a company, particularly if it is planning to reduce its revenue. However, remember that few industries can actually enjoy a negative working capital. It isn’t recommended for the highly risky and expensive automobile industry, for example.
Current ratio often depicts the ability of the company to pay back short-term loans. It helps measure the liquidity of the house.
It is often noted that the acceptable current ratios lie between 1.5 and 3 for healthy businesses. However, ratios may vary between this range for various industries.
So, this was all about calculating working capital. Remember that the working capital amount which hardly involves 4-5 balance sheet items, with usually the lowest amounts in the entire sheet, if ignored, can even lead to bankruptcy or at any rate, lead to short term debt settlement problems. How? If your current liabilities exceed the assets, and you don’t have liquid funds to pay your creditors, then the business might find itself in a real fix. Secondly, the working capital shows the efficiency in running the business. A low capital, generally, indicates that your debtors pay you slowly (your collections are low), while your creditors are a great deal more demanding. Hence, ensure that you get a favorable working capital for your business.