Working capital, or total current assets minus total current liabilities, refers to the additional current assets that a company holds on its balance sheet as a liquidity cushion. Most current assets are funded by current liabilities and are expected to be converted back to cash within 12 months for payments on current liabilities due in the same cycle.
Certain current assets may become illiquid at the time when cash is needed to meet short-term obligations, including inventory without a ready market. When avoiding liquidity issues that may hamper a company's financial strength, it is financially sound to maintain a certain amount of working capital so bills are paid on time; however, maintaining a working capital that is too high is inefficient. Below are some of the advantages of maintaining a low working capital.
Key Takeaways
- Working capital is calculated as total current assets minus total current liabilities.
- Maintaining a certain level of working capital is important for a company as it allows it to prepare for future cash needs.
- Working capital allows a company to meet its short-term obligations, such as debt payments and taxes.
- Having too high of a working capital, however, can be a sign of operational inefficiency.
- Some of the advantages of having a lower working capital include better investment effectiveness, improved operational efficiency, a shorter cash conversion cycle, and allowing for on-demand or just-in-time operations.
Increasing Investment Effectiveness
Deploying working capital can be a double-edged sword: it ensures liquidity but also ties up capital that could have been better invested elsewhere. Because working capital is the amount of current assets in excess of the amount of current liabilities, it is funded by long-term capital raised for investment purposes rather than operational maneuvers.
When investment capital is allocated away for short-term uses, it potentially reduces a company's investment effectiveness. As long as liquidity concerns are adequately addressed, low working capital is desired to ensure the effective use of long-term funds.
Improving Operational Efficiency
The amount of working capital required for each operating cycle is dependent on a company's operational efficiency. For example, the more a company can make in cash sales or the faster it can turn over inventories, the lower the amount of working capital it needs.
When a company maintains a low level of working capital, it can force itself to improve its operating efficiency so operating cash flows, coupled with additional working capital, can safely cover costs and expenses during operations. With too much funding tied up idly in working capital for liquidity backup, a company may become less concerned about operating efficiency.
Working capital is a financial metric used to evaluate the financial health of a company. In all financial analysis, it is imperative to use multiple financial metrics to paint a whole picture of a company's health.
Shortening the Cash Conversion Cycle
Even with a low level of working capital, companies can still have sales on credit if they try to make the collection process as short as possible. The sooner accounts receivable are converted to cash, the less working capital is required. Inventories also potentially tie up funds for long periods.
In addition to raw materials, finished products can remain unsold for some time, which further lengthens the cash conversion cycle. If a company wishes to maintain a low level of working capital, sales must be made promptly after production, so funds stay within the cash conversion cycle for as little time as possible.
On-Demand or Just-in-Time Operations
Working capital can be reduced to as close to zero without jeopardizing a company's ability to meet short-term obligations if the so-called on-demand or just-in-time (JIT) operations can be adopted. Under such an operating regime, a company holds little or no inventories of unused raw materials and unsold finished products. By having little or no funds parked in potentially illiquid assets, a company effectively deploys little or no working capital.
A company can achieve this stance by working in unison with raw materials suppliers in the supply chain and sales distributors in the distribution network. In other words, a company does not purchase inventory until it is needed for production or produce anything unless sales orders are received. This way, funds designated for working capital are released and put into more productive uses.
Working capital is necessary to ensure uninterrupted operations, but it does not contribute directly to revenue generation or profitability. On the contrary, having too much working capital may hinder a company's financial results when the funds sit idle until a liquidity need arises.
Suppose a company can maintain a low level of working capital without incurring too much liquidity risk. In that case, this level benefits a company's daily operations and long-term capital investments. Less working capital can lead to more efficient operations and more funds available for long-term undertakings.
What Are the Main Components of Working Capital?
Working capital compares current assets to current liabilities. In the current assets bucket, the most important components are cash, accounts receivable, and inventory. In the current liabilities bucket, accounts payable, short-term debt, and income taxes payable within a year are the most important.
Is Working Capital a Profit?
Working capital is not a profit. It is a financial metric that compares a company's current assets to its current liabilities. It is a measure of liquidity. The higher a company's current assets are in comparison to its current liabilities, the more liquid it is.
What Is a Good Working Capital?
A good working capital will vary based on the type of company but more specifically, the type of industry. Each industry has different liquidity requirements and ways of functioning; however, in general, a good working capital is considered to be between 1.5 and 2. When comparing working capital across companies, make sure you're comparing companies in the same industry for an apples-to-apples comparison.
The Bottom Line
Having a certain level of working capital is crucial to the financial health of a company. It allows companies to meet short-term obligations and maintain a certain level of liquidity whenever cash is needed. Maintaining too high a level of working capital, however, is inefficient, as a company can miss out on investment returns and improvements in operational efficiency.
