What is Working Capital? - Accounting Questions Answered
Working Capital is the number one reason why investors look at a company’s balance sheet because it depicts a picture of the financial health of the company. Working capital tells you about the cash position of a company and what would be left of it if it raised all its current assets to pay off all of its current short term liabilities. By calculating the working capital, accountants can tell whether a company has sufficient cash resources to continue its business operations, expand its business or have to turn to the bank for a loan.
The formula for calculating working capital is:
Working Capital = Current Assets – Current Liabilities
Current assets include cash, short term investments (cashable in 1 year or less), merchandise inventory, accounts receivable and prepaid expenses. Current liabilities include accounts payable, short term notes payable (those due in 1 year or less), short term debt & other accrued liabilities.
If a company has more current assets than current liabilities, than it will be able to pay its employees’ salaries, rent expenses & other operational expenses. However a company that has more current liabilities than current assets will likely have to borrow a bank from the loan and if the problem persists for longer periods of time, it will have to seek bankruptcy protection and cease all business operations.
The image on the left shows the Working Capital cycle where a single point of resource (the cash) is used to pay short term payables, buy inventory, collect its receivables, make sales and pay for other overheads.
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