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What Is Working Capital and Why Does It Matter?

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Here's a guide to working capital.

Working capital measures a business’s operating liquidity, but it does so much more. It also can be a good indicator of a company’s efficiency and financial health, as well as how well it manages debt, payroll, and inventory. These are all factors you want to keep in mind, especially if you’re considering investing in said company. Here’s how working capital work and why it’s important to investors and business owners.  

How Working Capital Works

Working capital, also called net working capital (NWC), is a measure of a company’s liquidity. That’s how much money it can produce in liquid assets, usually within the next 12 months.

That capital can also be a good indicator of operational efficiency and short-term financial health. For example, if it has a large amount of such capital, it could be poised to invest in its business and grow. But a deficit of working capital could signal a potential bankruptcy. 

Usually, the greater a company’s capital is, the better. It means their liquid assets (those that can be turned into cash within a year) outweigh their liabilities, such as payroll, debts, taxes, or other liabilities (due in the next 12 months). It also means they are effectively managing payments to vendors, payment collection, and inventory. 

A company’s liquid assets can include checking and savings accounts or liquid securities such as stocks, bonds, mutual funds and exchange-traded funds (ETFs). Money market accounts, accounts receivable, inventory, short-term prepaid expenses, and (of course) cash are all also considered liquid assets. As are assets of discontinued operations certain interest. However, they do not include illiquid assets including hedge funds or real estate.

Liabilities, meanwhile, can include rent, utilities, materials, and interest payments. Accrued income taxes and liabilities as well as accounts and dividends payable also show up on the liabilities list. Capital leases, future dividends and long-term debt can also be strikes against a company’s capital.

But greater capital isn’t always a good thing. In some cases, high working capital can signify a large amount of inventory.A recent expansion or product launch can temporarily decrease that capital, but be good for the overall health of the company. Additionally, some larger corporations have less working capital but can gain access to it in a pinch. 

How It’s Calculated 

Here's a guide to working capital.

Calculating such capital is relatively straightforward. You simply subtract a company’s current liabilities from its current assets.

  • Current Assets Current Liabilities = Working Capital. 

But there is also working capital ratio. That formula also indicates a company’s financial health. You can calculate it by dividing current assets by current liabilities. 

  • Current Assets/Current Liabilities = Working capital ratio

That capital generally should be a positive number, but not too high. Meanwhile, its ratio should be one or above. A ratio of one means a company has exactly the same of assets as it has liabilities, while a working capital ratio of two means it has twice the assets of liabilities. It proceeds in similar multiples from there.

What It’s Important 

Working capital is a vital measure of a company’s financial health, as well as its operational efficiency and liquidity. But it also reflects how well a company is managing debt, making payroll, earning revenue, and dealing with inventory. 

For business owners, such capital is important to day-to-day operations. That capital covers financial obligations including payroll, paying vendors, and meeting other obligations. 

A healthy amount of such capital often signifies good management. It reflects not just a company’s liquidity, but also its operational efficiency and how well its handling inventory, accounts payable and accounts receivable. It can tell you whether a company is solvent or is experiencing financial trouble. 

For investors, a strong capital figure often represents a good investment. It often shows that a company can meet its financial obligations. That capital also reflects how well a company manages inventory, debt, payments, and collections. Negative capital (or a ratio of less than one) can denote a riskier investment. 

The Bottom Line

Here's a guide to working capital.

Working capital measures a business’s operating liquidity by subtracting a company’s liabilities from its assets. A company’s working capital ratio also represents a company’s liquidity and financial health. It indicates company’s operational efficiency, liquidity, and overall financial health. 

If you’re considering investing in a certain company, be sure you research their such capital. While lower capital could mean its a riskier investment. higher capital could signify solvency and a smarter investment.

Investment Tips
  • If you’re looking to invest and a company’s working capital still doesn’t look quite right to you, consider consulting a financial advisor. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in 5 minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.
  • Discerning a good investment from a bad one often requires more measures than a company’s capital. If you’re just getting started as an investor, SmartAsset’s investment guide can help you determine your risk threshold and find investments that fit your portfolio.

Photo credit: iStock.com/ipopba, iStock.com/utah778, iStock.com/South_agency

The post What Is Working Capital and Why Does It Matter? appeared first on SmartAsset Blog.

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