August 13, 2011

What is Working Capital?

Working Capital (WC) is one of the measures used in checking the liquidity status of a firm. Short-term lenders look at this measure to determine, over time if the firm is able to provide cover for funds entrusted to it by lenders.

It is the the difference between the figures of Current Assets and Current Liabilities. At various levels it indicates how well the managers have been able to manage the liquidity position of their firm. Liquidity is one of the most crucial considerations in the business world. It should be noted that an optimal level is the aim as all assets have costs attached to them – excess cash shows lack of financial dexterity.

Working capital is the meeting of day to day expenses of a company.

Talking in regards to the performance of a company, Current assets and current liabilities are to be taken into account and are to be valuated. We got to understand the indepth parameters used in working capital i.e. current assets and liabilities. Current assets are high, if yes why ? Current liabilities are high if yes why ? should be the primary question.

For example the ratio of current assets to current liabilities is high :
The liquidity ratio is high it means current liabilities is low or current assets is high. Both are possible at the same time. If current assets are high then the source for high current assets should be understood. If inventory is high then the reason for such inventory should be understood. Ordering costs and carrying costs should be analysed.
Investment in marketable securities and cash in hand should be analysed with respect to the current liabilities and interest paid towards these current liabilities. The opportunity costs should be taken into account.

In a healthy company, it is good to see a high liquidity ratio but it should be carefully analysed before declaring it to be a healthy company.

So working capital has to be supported with above analysis and further decisions can be taken to achieve the objectives.Working capital alone can be used to check whether the company can meet its expenses or not, which estimates the liquidity position of the company and thus helps in rating and issuing credit by the creditors etc. It helps to rank the company in terms of its liquidity.