What Is Working Capital ?
Working capital is the capital invested in current activities for the period of each operating cycle. It is involved in only one production cycle and completely transfers its value to products. On the contrary, fixed capital is repeatedly involved in the production process and transfers its value to products in parts. Therefore, working capital circulates faster than fixed capital. With an increase in the share of working capital in the total amount of advanced capital, the turnover time of the entire capital decreases.
Working capital is characterized not only by the volume and structure, but also by the liquidity of current assets. It is taken into account that, for example, inventories are less liquid than finished products, and cash is absolutely liquid.
In accounting, working capital is called working assets by the means that the manufacturing company uses for its daily activities and which are fully consumed within the same production cycle.
Features of working assets management are determined by the structural affiliation of business entities. For example, in the field of production, the structure of working capital is determined by the degree of concentration, the nature and duration of the production process, its material consumption, technical equipment, and other factors. At retail enterprises, the share of inventory holdings is higher. Financial corporations are dominated by cash and cash equivalents.
According to the sources of formation, working assets are divided into own and borrowed (attracted). Own working capital of enterprises provides financial stability and operational independence of an economic entity. The borrowed capital, attracted in the form of bank loans and other forms, covers the additional need of the enterprise for funds.
To assess the effectiveness of working assets management, enterprises typically use the turnover indicators for various types of assets and liabilities. Based on them, the technology for the application of methods for managing receivables, free cash balances and other types of assets is being built. Such an assessment, for example, helps to benefit from the use of free cash or slowing down the payables turnover period.
Working capital turnover is the duration of one full circulation of funds, starting from the first to the third phase. The faster the working assets go through these phases, the more products the company can manufacture with the same amount of working capital. In different business entities, the turnover of working assets depends on the specifics of production and the conditions of sale of products, features in the structure of working capital, enterprise solvency, and other factors.
The phases are as follows:
- The working assets, initially in the form of cash, are converted into inventories, that is, they are transferred from the circulation to the production sphere.
- Current assets participate directly in the production process and take the form of work in progress, semi-finished products, and finished products.
- The third phase takes place again in the sphere of circulation. As a result of the sale of finished products, current assets again take the form of cash.
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How to Calculate Working Capital
The net working capital for the enterprise is calculated as the difference between current assets and current liabilities. If the working assets turn out to be zero, it means that the current assets of the company are fully formed using loans. However, the company can pay off all its short term debts without resorting to the sale of less liquid fixed assets. When the result is greater than zero, part of the capital is involved in the formation of current assets. Such a value is desirable and corresponds to the equilibrium state of the balance sheet items. If the number is negative (i.e., less than zero), this means that the company lacks internal sources and even its fixed assets are partially formed by short term obligations. This does not correspond to the equilibrium state of the balance. Such a result indicates that the company is financially unstable.
Why Is Working Capital Important?
The role of working assets in an efficiently operating subject of the modern economy is dominant. Especially, this role is important in times of economic crisis.
Working capital management is important in solving the key problem of the financial condition. Specifically, it is achieving the optimal ratio between the growth of production profitability (maximizing profit on invested capital) and ensuring sustainable solvency as an external manifestation of the company’s financial stability. An extremely important task is to maintain a balance between own working assets and borrowed resources. The efficiency of capital use is determined by the results of its functioning and the relationship with the costs necessary to obtain these results.
The main objectives of efficiency analysis for working capital are:
- Determination of the effect of profit on capital.
- Establishment of capital gains.
- Assessment of how the working assets impact the company’s financial situation.
Working capital is one of the most important categories of a market economy. Its insufficiency or inefficient use can negatively impact the financial condition of the organization. It impacts the change in all key indicators of the organization: the volume of output, labor productivity, cost, etc. In this regard, there is a need for effective working assets management both at the level of a single organization and throughout the entire economy. The development of market relations has provided organizations with additional opportunities in choosing the forms and methods of working capital management.
The Bottom Line
Working capital is the value expression of labor objects that participate in direct production only once and fully transfer their value, indicated in the production process, to the cost of the product itself. The role of working assets is to ensure the continuity of production cycles and stabilize the activities of economic entities for their successful progressive development.
Now you know what is working capital, why is working capital important, and how to calculate working capital. For more definitions, refer to our financial dictionary at https://www.monfex.com/financial-dictionary