What is working Capital?

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Working Capital is a financial indicator of operational liquidity of a business organization. Working Capital is the short term assets to cover the short term liabilities of the organization. Working Capital is calculated as Current Assets – Current Liabilities, also represented as Net Working Capital. The Working Capital Ratio or Current Ratio is calculated as Current Ratio/ Current Liabilities. Current ratio anything below 1 indicates a negative working capital, and anything above 2 indicate that working capital management of the business is not good since the excess of current assets are not invested. Generally current ratio of 1.33 is taken as an ideal ratio.

Also read – Analysis of holding levels for working capital assessment

Another way of representing working capital is the portion of Long Term Funds to cover current assets. So even if you calculate working capital by deducting Fixed Assets and Long Term Investments from Long Term Funds, the result will be same as calculated by deducting current liabilities from current assets.

For e.g. if balance sheet of ABC Ltd. is as under:

Liabilities Rs. In Crores Assets Rs. In Crores
Share Capital 100 Net Fixed Assets 80
Long Term Loans 50 Long Term Investments 40
Current Liabilities 80 Current Assets 110
Total Liabilities 230 Total Assets 230

Now, we calculate working capital by both the methods:

Current Assets – Current Liabilities 110 – 80 = 30
Long Term Funds (Share Capital + Long Term Loans) – (Fixed Assets + Long Term Investments (100+50) – (80+40) = 30

Also Read – How assessment of Term Loan is done

Now, see the logic behind working capital. Positive working capital indicate that the organization have sufficient long term funds to cover its long term needs and short term funds are not utilized for acquiring fixed asset. Negative working capital indicates that the organization have utilized its short term funds for acquiring long term assets. So what’s wrong is utilizing short term funds for acquiring long terms assets? Let’s take an example:

Liabilities Rs. In Crores Assets Rs. In Crores
Share Capital 100 Net Fixed Assets 120
Long Term Loans 50 Long Term Investments 60
Current Liabilities 80 Current Assets 50
Total Liabilities 230 Total Assets 230

In this case working capital is negative 30 crores. It indicates that the organization has utilized 30 crores of its short term funds for long term needs. Now, you know that short term funds are required to be paid in a short period (less than 1 year), whereas, long term assets can not be sold (used) for making payment for short term loans. How will company, repay the current liabilities of 80 crores from current assets of 50 crore only. So, in this case, the organization would be in a liquidity crunch.

To understand, what are current assets and what are current liabilities and how to identify current assets and current liabilities in a balance sheet read this article.