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What is Working Capital?

The capital required by a business can be divided into two broad categories – fixed capital and working capital. Fixed capital refers to the amount invested in long-term assets. This category of capital is not consumed during the production process. Many entrepreneurs ask us what is working capital. Working capital refers to the amount invested in current assets.

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What is Working Capital?

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  1. What is Working Capital?

  2.  The capital required by a business can be divided into two broad categories – fixed capital and working capital. Fixed capital refers to the amount invested in long-term assets.  This category of capital is not consumed during the production process. Many entrepreneurs ask us what is working capital. Working capital refers to the amount invested in current assets.  Also, working capital can be defined as the Investment required by an enterprise to fund its day-to-day operations. Hence, working capital is calculated by deducting current liabilities from current assets.

  3. Formula for Calculating Working Capital One can calculate working capital of an enterprise with this formula. Working Capital = Current Assets – Current Liabilities Current assets include the assets that can convert into cash quickly. Hence, current assets include cash in hand, cash at bank, bills receivables, and inventory. At the same time, current liabilities refer to the debts the business needs to repay within the same accounting year. Hence, one can calculate the working capital by deducting the short-term debts of the business from its short-term assets.

  4. Importance of Working Capital While processing credit requests, lending institutions assess the business’s financial health based on its working capital. They consider the business to be healthy if its current assets exceed current liabilities by a huge margin. On the other hand, if the current liabilities exceed current assets, the business is considered to be in critical stage. The business owners have to infuse additional funds to meet concurrent working capital needs and sustain growth. It is always important for the entrepreneur to maintain positive working capital to discharge current liabilities on time and maintain positive cash flow position.

  5. Working Capital Ratio A business can assess its financial health precisely based on working capital ratio. It can calculate working capital ratio by applying this simple formula. Working Capital Ratio = Current Assets/Current Liabilities If the working capital ratio is below 1, the business has a negative working capital. It must arrange funds immediately to repay short-term debts on time and maintain a positive cash flow position. On the other hand, the business has more than required funds, if the working capital ratio is above 2. It must explore ways to reinvest the surplus working capital efficiently to get higher returns. However, the business must focus on maintaining positive cash flow if the working capital ratio ranges from 1.2 to 2.

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