Working capital - wikipedia Working capital This article needs additional citations for verification. Please help improve this article by adding citations to reliable sources. Unsourced material may be challenged and removed. ( May 2014 ) Working capital ( abbreviated WC ) is a financial metric which represents operating liquidity available to a business, organisation or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. A company can be endowed with assets and profitability but short of liquidity if its assets can not readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short - term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash. Contents 1 Calculation 1.1 Inputs 2 Working capital cycle 2.1 Definition 2.2 Meaning 3 Working capital management 3.1 Decision criteria 3.2 Management of working capital 4 See also 5 References 6 External links Calculation Working capital is the difference between the current assets and the current liabilities. The basic calculation of the working capital is done on the basis of the gross current assets of the firm. Working Capital = CURRENT ASSETS − CURRENT LIABILITIES ( displaystyle ( \text ( Working Capital ) ) = ( \text ( CURRENT ASSETS ) ) - ( \text ( CURRENT LIABILITIES ) ) ) Inputs Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact : accounts receivable ( current asset ) inventory ( current assets ), and accounts payable ( current liability ) The current portion of debt ( payable within 12 months ) is critical because it represents a short - term claim to current assets and is often secured by long - term assets. Common types of short - term debt are bank loans and lines of credit. An increase in net working capital indicates that the business has either increased current assets ( that it has increased its receivables or other current assets ) or has decreased current liabilities -- for example has paid off some short - term creditors, or a combination of both. Working capital cycle Definition The working capital cycle ( WCC ) is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is tying up capital in its working capital without earning a return on it. Therefore, companies strive to reduce their working capital cycle by collecting receivables quicker or sometimes stretching accounts payable. Meaning A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. For example, a company that pays its suppliers in 30 days but takes 60 days to collect its receivables has a working capital cycle of 30 days. This 30 - day cycle usually needs to be funded through a bank operating line, and the interest on this financing is a carrying cost that reduces the company 's profitability. Growing businesses require cash, and being able to free up cash by shortening the working capital cycle is the most inexpensive way to grow. Sophisticated buyers review closely a target 's working capital cycle because it provides them with an idea of the management 's effectiveness at managing their balance sheet and generating free cash flows. As an absolute rule of funders, each of them wants to see a positive working capital. Such situation gives them the possibility to think that your company has more than enough current assets to cover financial obligations. Though, the same ca n't be said about the negative working capital. A large number of funders believe that businesses ca n't be sustainable with a negative working capital, which is a wrong way of thinking. In order to run a sustainable business with a negative working capital, it 's essential to understand some key components. 1. Approach your suppliers and persuade them to let you purchase the inventory on 1 - 2 month credit terms, but keep in mind that you must sell the purchased goods, to consumers, for money. 2. Effectively monitor your inventory management, make sure that it 's often refilled and with the help of your supplier, back up your warehouse. Plus, big companies like McDonald 's, Amazon, Dell, General Electric and Wal - Mart are using negative working capital. Working capital management Corporate finance Working capital Cash conversion cycle Return on capital Economic value added Just - in - time Economic order quantity Discounts and allowances Factoring Sections Managerial finance Financial accounting Management accounting Mergers and acquisitions Balance sheet analysis Business plan Corporate action Societal components Financial law Financial market Financial market participants Corporate finance Personal finance Peer - to - peer lending Public finance Banks and banking Financial regulation Clawback Decisions relating to working capital and short - term financing are referred to as working capital management. These involve managing the relationship between a firm 's short - term assets and its short - term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short - term debt and upcoming operational expenses. A managerial accounting strategy focusing on maintaining efficient levels of both components of working capital, current assets, and current liabilities, in respect to each other. Working capital management ensures a company has sufficient cash flow in order to meet its short - term debt obligations and operating expenses. Decision criteria By definition, working capital management entails short - term decisions -- generally, relating to the next one - year period -- which are `` reversible ''. These decisions are therefore not taken on the same basis as capital - investment decisions ( NPV or related, as above ) ; rather, they will be based on cash flows, or profitability, or both. One measure of cash flow is provided by the cash conversion cycle -- the net number of days from the outlay of cash for raw material to receiving payment from the customer. As a management tool, this metric makes explicit the inter-relatedness of decisions relating to inventories, accounts receivable and payable, and cash. Because this number effectively corresponds to the time that the firm 's cash is tied up in operations and unavailable for other activities, management generally aims at a low net count. In this context, the most useful measure of profitability is return on capital ( ROC ). The result is shown as a percentage, determined by dividing relevant income for the 12 months by capital employed ; return on equity ( ROE ) shows this result for the firm 's shareholders. Firm value is enhanced when, and if, the return on capital, which results from working - capital management, exceeds the cost of capital, which results from capital investment decisions as above. ROC measures are therefore useful as a management tool, in that they link short - term policy with long - term decision making. See economic value added ( EVA ). Credit policy of the firm : Another factor affecting working capital management is credit policy of the firm. It includes buying of raw material and selling of finished goods either in cash or on credit. This affects the cash conversion cycle. Management of working capital Guided by the above criteria, management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets ( generally cash and cash equivalents, inventories and debtors ) and the short - term financing, such that cash flows and returns are acceptable. Cash management. Identify the cash balance which allows for the business to meet day to day expenses, but reduces cash holding costs. Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials -- and minimizes reordering costs -- and hence increases cash flow. Besides this, the lead times in production should be lowered to reduce Work in Process ( WIP ) and similarly, the Finished Goods should be kept on as low level as possible to avoid overproduction -- see Supply chain management ; Just In Time ( JIT ) ; Economic order quantity ( EOQ ) ; Economic quantity Debtors management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital ( or vice versa ) ; see Discounts and allowances. Short - term financing. Identify the appropriate source of financing, given the cash conversion cycle : the inventory is ideally financed by credit granted by the supplier ; however, it may be necessary to utilize a bank loan ( or overdraft ), or to `` convert debtors to cash '' through `` factoring ''. See also Cash conversion cycle Overtrading Quick ratio analysis Sustainable growth rate Working capital management References Jump up ^ Gross Working Capital vs Net working Capital Jump up ^ `` Negative Working Capital : Definition & Examples ''. Inevitable Steps. August 18, 2015. Retrieved February 21, 2016. External links How to Calculate Working Capital Value Based Working Capital Management Working Capital Management and Profitability Case of Pakistani Firms Impact of Working Capital Management on Firms ' Performance : Evidence from Non-Financial Institutions of KSE - 30 index Types of capital By form Academic Accumulation of capital Circulating / Floating Cultural Cross-cultural Educational Financial Fixed Human Individual Information Instructional Intellectual Natural Intangible Organizational Physical Political Public Sexual Social Symbolic Venture Working By term Liquid ( short ) vs. Patient ( long ) Marxist analytical Constant Variable Fictitious Marxist historical Monopoly Financial capital Retrieved from `` https://en.wikipedia.org/w/index.php?title=Working_capital&oldid=851794528 '' Categories : Financial capital Working capital management Hidden categories : Articles needing additional references from May 2014 All articles needing additional references All articles with unsourced statements Articles with unsourced statements from October 2017 Talk Contents About Wikipedia Azərbaycanca Català Čeština Deutsch Eesti Español Euskara فارسی Français 한국어 Հայերեն Italiano עברית Қазақша Latviešu Lietuvių Македонски Nederlands नेपाली 日本 語 Norsk Polski Português Русский Suomi Svenska Українська Tiếng Việt 中文 21 more Edit links This page was last edited on 24 July 2018, at 17 : 05 ( UTC ). 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Question: the primary reason that a firm has an investment in working capital is to
Answer: ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses