Necessity of Working Capital

No business can continue to operate if they don’t pay their bills. Because of that it is important to keep tabs on your company’s ability to pay bills on time. There are several financial indicators of this ability, among them being the quick ratio, current ratio, and working capital. For now let’s look at the necessity of working capital.

A Definition

The definition of working capital is simply Current Assets – Current Liabilities. Though the definition is simple there is more to consider. That includes the quality of current assets and the likelihood they can be converted to cash as needed. But, that discussion is for another time. For now, let’s just assume that is not an issue and only look at the working capital.

Why Working Capital Matters

The necessity of working capital is that without it your company will be hampered in not only the ability to grow, but also in normal day-to-day operations. Essentially working capital represents how much ability you have to cover current liabilities. Here are some examples of working capital calculations and the ramifications:
working capital

In example 1 the indication is that there should be plenty of cash to cover current liabilities as they come due, assuming there are not significant issues with the quality of the current assets like receivables and inventory.

In example 2 it appears that the company is able to cover their current liabilities. Here any quality issues with the current assets may create a problem paying obligations when they are due. They will need to be diligent in managing the balance sheet.

In example 3 the company has negative working capital of $100,000 and will likely be hard-pressed to pay bills in a timely manner.

Keep in mind that the current liabilities in all of these examples may not include everything that will to be due soon. For example, a payroll that may need to be paid in the next few days may not be showing up in current liabilities. So, that means not to look at working capital in an isolated manner. Also look at things that may not yet be reflected in the current liabilities.

So What Does This All Mean?

Basically the three examples show the consequences of various financial positions. They demonstrate how important it is to keep a close watch on working capital levels and to take corrective action to maintain adequate liquidity. Without that liquidity your business will struggle.

Does management at your company understand the necessity of working capital? If you need some help on understanding all this and suggestions on how to improve your condition, please contact AimCFO today.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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