Understanding Working Capital (WC)
Working capital is a crucial balance sheet calculation since it is considered to reveal a great deal about a company’s financial condition. And this is how to calculate it from a balance sheet:
WC = Current Assets – Current Liabilities
The idea behind the formula is what a company would have left after it used all its short-term resources to pay off all its short-term liabilities. As you may know, current assets are supposed to be quickly transferred into cash. Having positive working capital or current assets exceed current liabilities, at some levels, guarantees a company’s ability to pay all the bills coming due.
Why it’s important
It is a measure of a company’s liquidity and operational efficiency. Liquidity is an important concern for financial managers. A firm with fixed assets worth billions of dollars may declare bankruptcy due to inability to pay due bills. Working capital position of a company can show whether it has necessary resources to expand without raising additional funds. Insufficient working capital management can pose some serious threats to a company’s financial health in short term by increasing borrowing and the numbers of late payments. All of this can lead to high cost of capital since corporate credit rating is eventually lower.
Negative working capital
By definition, it is the situation when current liabilities exceed current assets. People usually assume this is a bad sign for a business. Their argument may be how you can do business while you can’t cover your bills. However, let’s consider a business having a quick cash conversion, which means it can sell a product to the customer and collect cash before it has had to pay its bill to the vendor. To maximize efficiency, a company don’t need to have much cash in hand as new cash is constantly generated to meet the liabilities of paying its account payable. Negative working capital at its best is actually a way for a business to expand on other people’s money.