Working capital
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Working capital is a valuation metric that is calculated as current assets minus current liabilities. Also known as operating capital, it represents the amount of day-by-day operating liquidity available to a business. A company can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash.
Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:
- accounts receivable (current asset)
- inventory (current assets), and
- accounts payable (current liability)
In addition, the current (payable within 12 months) portion of debt is critical, because it represents a short-term claim to current assets. Common types of short-term debt are bank loans and lines of credit.
Any change in the working capital will have an effect on a business's cash flows. A positive change in working capital indicates that the business has paid out cash, for example in purchasing or converting inventory, paying creditors etc. Hence, an increase in working capital will have a negative effect on the business's cash holding. However, a negative change in working capital indicates lower funds to pay off short term liabilities (current liabilities), which may have bad repercussions to the future of the company.
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