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Understanding Working Capital

Posted on March 22, 2021 By

Working capital, also referred to as net working capital, is the measure of a company's liquidity, operational efficiency, and short-term financial status. It is the difference between a business’s current assets, its inventory of materials and goods, and its existing liabilities. Net operating working capital is the difference between current assets and non-interest-bearing current liabilities. Typically, they are both calculated similarly, by deducting current liabilities from the current assets. So, essentially, if a business’s current assets total $500,000 and its current liabilities are $100,000, then its working capital is $400,000. But there are a few variations on the calculation formula based on what a financial analyst wants to include or exclude:

Current Assets – Current Liabilities = Working Capital

Current Assets (less cash) – Current Liabilities (less debt) = Working Capital

Accounts Receivable + Inventory – Accounts Payable = Working Capital

The first is the broadest, as it includes all accounts. The second formula is narrower. The last formula is the most narrow in scope since it only includes three accounts. 

Current assets are considered short term and can include cash, cash equivalents, accounts receivable, pre-paid liabilities, and inventory. These assets are expected to be liquidated in one year or less. Current liabilities are also short term (due within one year) and usually include accounts payable, short-term debt, wages, taxes owed, maturities of long-term debt, and deferred revenues.

If a business has ample positive working capital, it has the ability to continue to fund its operations and offers potential for future growth. On the other hand, if the company has negative working capital, its current assets do not surpass its current liabilities, and it may face problems with growth or the ability to pay off debt.

High Working Capital

A company that has high working capital is usually functioning efficiently, financially healthy, and has the resources to meet its monetary obligations. It is often a sign that the business is well managed and is primed for growth. However, it is important to note that high working capital can sometimes be a sign of trouble. It may mean that the company is sitting on too much inventory, or it is not investing enough of its excess cash.

In contrast, low working capital often indicates distress or risk of default.

Negative Working Capital 

When the balance sheet shows negative working capital, it can mean that the business is not liquid enough to pay its bills and sustain growth for the next year. But this isn’t always the case. For businesses that have high inventory turns and work on a cash basis, negative working capital can be a good thing. These types of businesses, such as grocery stores, make fast cash every day that can be stockpiled and invested in inventory. They do not really have a need for having large amounts of working capital on hand.

On the other hand, businesses that sell expensive items on a long-term payment basis are unable to generate quick cash. They also have to order inventory in advance, making it difficult to sell it fast enough to raise capital needed to weather a financial emergency. There are large, successful corporations that have negative working capital, but in order to remain solvent, these companies are typically massive and have significant brand recognition. These corporations are also able to generate more funds by moving money around or by acquiring long-term debt.

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How Working Capital Can Impact Cash Flow

Investment into working capital is often needed to fund major initiatives, such as an expansion into new markets or new products, and the result is reduced cash flow. Cash flow can also be reduced if sales are down, or if accounts receivable is being recovered too slowly. The inefficient use of working capital can be reversed through a boost in cash flow, which usually requires the passing of costs onto customers and suppliers. This may not always be the best strategy for the business.

The Importance of Working Capital

Working capital is necessary in order for a company to remain solvent. It cannot rely on accounting profits to pay bills that need to be paid with cash on hand. For example, say a company has accumulated $500,000 in cash from the prior years’ retained earnings. If that company invested all $500,000 at once, they may not have sufficient current assets to cover their current liabilities.

There are several reasons why a company might need more working capital. Many businesses will face times when additional working capital is needed to pay employees and suppliers while waiting on payments from customers. Some businesses see seasonal differences in cash flow. These companies may need extra capital to get ready for a busy season, or to keep things running during a slow season. Extra working capital can also enable a business to leverage supplier discounts and buy in bulk, or to pay temporary staff or cover other expenses.

One advantage of assessing a business’s working capital position is that it enables a future picture of any financial difficulties that could crop up. Even a profitable company with billions in fixed assets can end up facing bankruptcy if the bills can’t be paid.

Low levels of working capital can result in a company feeling financially pressured, causing it to borrow more and pay bills late. All of this, in turn, can lead to a lower corporate credit rating, which means higher interest rates that are bad for the bottom line.

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Americas: Sam Smoot at +1 (813) 898 2350 / Smoot@BenchmarkIntl.com

Europe: Michael Lawrie at +44 (0) 161 359 4400 / Enquiries@BenchmarkIntl.com

Africa: Anthony McCardle at +27 21 300 2055 / McCardle@BenchmarkIntl.com 

ABOUT BENCHMARK INTERNATIONAL

Benchmark International’s global offices provide business owners in the middle market and lower middle market with creative, value-maximizing solutions for growing and exiting their businesses. To date, Benchmark International has handled engagements in excess of $6B across various industries worldwide. With decades of global M&A experience, Benchmark International’s deal teams, working from offices across the world, have assisted hundreds of owners with achieving their personal objectives and ensuring the continued growth of their businesses.

Website: http://www.benchmarkintl.com
Blog: http://blog.benchmarkcorporate.com

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