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This article was co-written by Darron Kendrick, CPA, MA. Darron Kendrick is a visiting professor of accounting and law at the University of North Georgia. He received his master’s degree in tax law from Thomas Jefferson School of Law in 2012 and his CPA degree from the Alabama Commission on Public Accountants in 1984.
This article has been viewed 144,601 times.
Working capital is a measure of cash and current assets available, serving the company’s day-to-day operational needs. Mastering this information will aid your business management and help you make the right investment decisions. By calculating working capital, you can determine whether a business is capable of meeting its short-term obligations and, at the same time, how long it will take to do so. With little or no working capital, the future of the business may not look so good. Working capital is also useful in assessing how efficiently a business is using its resources. [1] X Research Source The formula for calculating working capital is:
Working capital = current assets – current liabilities [2] X Research source
Steps
Make simple calculations
- Typically, you can find this information on a company’s balance sheet – this should include a section on total current assets.
- If the balance sheet does not include total current assets, examine each line of the balance sheet. Add up all accounts that meet the short-term asset definition to get the required sum. For example, you would add the parameters “accounts receivable”, “inventory”, “cash and equivalents”.
- The balance sheet should show total short-term debt. If not, use the information on the balance sheet to find this total by adding up the short-term liabilities listed. For example, they might include “accounts payable and provisions”, “tax payable” and “current liabilities”.
- For example, suppose a company has current assets of VND 1 billion and current liabilities of VND 480 million. The company’s working capital will be VND 620 million. With current current assets, the company can pay off all short-term liabilities and at the same time, have cash to serve other purposes. The company can use cash for business operations or to pay off long-term debt. It can also be used to pay dividends to shareholders.
- If current liabilities are greater than current assets, the result indicates a shortfall in working capital. [6] X Research Source Working capital shortage is a warning sign that the company is in danger of default. In this situation, the company may need other long-term financing sources. It could be a sign that the company is in trouble and, perhaps, not a good investment choice.
- For example, suppose the company has 2 billion dong of current assets and 2.4 billion dong of short-term debt. The company’s working capital was short of 400 (or – 400) million dong. In other words, the company will not be able to meet its short-term obligations and must sell its long-term assets equivalent to VND400 million or find other sources of financing.
Understanding and managing working capital
- A ratio is a way of comparing two values and the relationship between them. [8] X Research Source Calculating ratios is often just a simple division problem.
- To calculate the current ratio, divide current assets by current liabilities. Current ratio = current assets ÷ current liabilities. [9] X Research Source
- Continuing with the example in part 1, the company’s short-term ratio is 1,000,000,000 ÷ 480,000,000 = 2.08. That is, the company has current assets 2.08 times more current liabilities.
- The ideal short-term ratio is around 2.0. [11] X Research Source A coefficient low or below 2.0 may indicate a greater risk of default. On the other hand, a coefficient exceeding 2.0 could be a sign that management is too safe and not ready to take advantage of existing opportunities. [12] X Research Source
- Given the above example, a short-term ratio of 2.08 is probably a healthy indicator. You can interpret this index to show current assets that can fund short-term liabilities of slightly more than two years. Here, of course, we implicitly assume that short-term debt is maintained at current levels.
- Different industries have different acceptable short-term ratios. Some industries are capital intensive and may need debt to meet operational needs. For example, a manufacturing company often has a high short-term ratio.
- For example, a company with too little working capital risks not being able to pay its short-term liabilities. However, keeping too much working capital can also be bad. Companies with lots of working capital can invest in long-term productivity improvements. For example, working capital surplus can be used to invest in a manufacturing facility or retail store. These types of investments can increase future revenue.
- When working capital is too high or too low, refer to the tips below for some ideas on improving short-term ratios.
Advice
- Manage payment credit recipients to avoid late payment from customers. In case you need to collect money urgently, consider the discount policy when paying early. [14] X Research Source
- Paying short-term debt at maturity. [15] X Research Source
- Don’t buy a fixed asset (like a new factory or building) with short-term debt. Converting fixed assets into cash fast enough to repay debt is very difficult to do. It will affect your working capital. [16] X Research Source
- Manage inventory levels. Try to avoid shortages or excesses. Many manufacturers use just-in-time (JIT) systems for inventory management because it is cost-effective. It also takes up less space and reduces inventory damage. [17] X Research Source
This article was co-written by Darron Kendrick, CPA, MA. Darron Kendrick is a visiting professor of accounting and law at the University of North Georgia. He received his master’s degree in tax law from Thomas Jefferson School of Law in 2012 and his CPA degree from the Alabama Commission on Public Accountants in 1984.
This article has been viewed 144,601 times.
Working capital is a measure of cash and current assets available, serving the company’s day-to-day operational needs. Mastering this information will aid your business management and help you make the right investment decisions. By calculating working capital, you can determine whether a business is capable of meeting its short-term obligations and, at the same time, how long it will take to do so. With little or no working capital, the future of the business may not look so good. Working capital is also useful in assessing how efficiently a business is using its resources. [1] X Research Source The formula for calculating working capital is:
Working capital = current assets – current liabilities [2] X Research source
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