Working Capital


  • What is Working Capital? 
  • How to Calculate Working Capital 
  • Components of Working Capital Calculation 
  • Working Capital and its Relationship with the Balance Sheet 
  • Working Capital and Cash Flow 
  • Working Capital Management and Financial Ratios 
  • Current Ratio and Quick Ratio in Working Capital Assessment 
  • Strategies to Boost Working Capital 

What is Working Capital? 

Working capital represents the funds an entity has available for its day to day operations. It’s calculated by subtracting current liabilities from current assets. Essentially, it’s the money available for covering short term expenses like salaries and purchasing materials. Monitoring working capital helps business owners assess their short term financial health and operational efficiency.  

Working capital holds significance because it sustains an entity’s day to day operations and ensures it meets short term financial obligations. Sufficient working capital enables businesses to pay employees, suppliers, taxes, and interest even during cash flow challenges. It also facilitates business expansion without relying heavily on debt.  

Demonstrating positive working capital enhances the entity’s credibility when seeking loans or credit. Finance teams aim to maintain visibility on available cash and ensure there’s enough working capital to cover liabilities while allowing room for growth and unexpected situations. 

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How to Calculate Working Capital 

In accordance with AASB 101, working capital is calculated by assessing current assets and liabilities, which are crucial for understanding an entity’s short term financial health 

To compute working capital, use a straightforward formula: 

Working Capital = Current Assets – Current Liabilities 

Current assets encompass cash and assets convertible to cash within a year, like inventory, accounts receivable, and securities. Conversely, current liabilities comprise obligations due within a year, such as accounts payable, taxes, and payroll. 

A positive working capital signifies that an entity possesses adequate assets to offset its short term liabilities. Conversely, a negative working capital suggests possible financial difficulties, indicating the business might encounter challenges in meeting its short term obligations. 

Components of Working Capital Calculation 

The components included in working capital calculations include both current assets and liabilities: 

Current assets consist of liquid assets convertible to cash within a year, such as: 

  • Cash holdings, including bank balances and pending customer cheques 
  • Marketable securities, like stocks or bonds 
  • Short term investments intended for sale within a year 
  • Accounts receivable, adjusted for potential uncollectible accounts 
  • Notes receivable, such as short term customer or supplier loans maturing within a year 
  • Other receivables, like tax refunds, employee cash advances, and insurance claims 
  • Inventory, comprising raw materials, work in progress, and finished goods 
  • Prepaid expenses like insurance premiums 
  • Advance payments for future purchases 

Current liabilities include all obligations due within a year, including: 

  • Accounts payable to suppliers 
  • Short term notes payable 
  • Accrued wages 
  • Outstanding taxes 
  • Loan interest due within the year 
  • Loan principal repayments within the year 
  • Other accrued expenses 
  • Deferred revenue, representing advance customer payments for undelivered goods or services 

As per AASB 101 Presentation of Financial Statements, the clear distinction between current and non current assets and liabilities lays the groundwork for assessing an entity’s liquidity and operational efficiency through working capital analysis. 

Working Capital and its Relationship with the Balance Sheet 

Working capital, a crucial financial metric, is derived from the figures reported in an entity’s balance sheet. The balance sheet, structured in accordance with AASB 101, highlights an entity’s current assets and liabilities, offering insights into its working capital. 

Think of the balance sheet as a snapshot capturing an entity’s financial position at a specific point in time, typically at the end of a quarter or fiscal year. It delineates the entity’s assets, liabilities, and shareholders’ equity comprehensively. 

Assets and liabilities are categorised on the balance sheet. Assets are arranged by liquidity, starting with the most liquid assets like cash and cash equivalents, followed by less liquid ones such as inventory and property.  

Liabilities are also categorised, with current liabilities, which are due within a year, listed first, followed by long term liabilities. This structure provides a clear depiction of an entity’s financial health and its ability to meet its short and long term obligations. 

Tax payment and tax deduction planning involve strategies to minimize tax liability.

Working Capital and Cash Flow 

Cash flow, defined as the movement of cash and cash equivalents in and out of a business over a specific period, is crucially reflected in an entity’s cash flow statement. This statement provides a comprehensive summary of cash inflows and outflows. 

The dynamics of cash flow significantly impact an entity’s working capital. The AASB 107 give clear insights into how cash flow impacts working capital management. 

For instance, if an entity experiences a decline in revenue leading to negative cash flow, it tends to deplete its working capital. Similarly, investments aimed at expanding production can also lead to a reduction in working capital as funds are allocated towards such endeavours. 

Now, concerning Working Capital vs. Net Working Capital, the terms are often used interchangeably, both denoting the disparity between all current assets and current liabilities. However, some analysts differentiate net working capital by refining its scope. 

For instance, one interpretation excludes cash and debt from the calculation: 

Net working capital = Current assets (excluding cash) – Current liabilities (excluding debt) 

Alternatively, a more stringent definition zeroes in on specific components, namely accounts receivable, accounts payable, and inventory: 

Net working capital = Accounts receivable + Inventory – Accounts payable 

These distinctions offer varying insights into an entity’s financial health and operational efficiency, allowing analysts to assess its liquidity and ability to meet short term obligations. 

Working Capital Management and Financial Ratios 

Working capital management is a financial strategy aimed at optimising the utilisation of working capital to cover day to day operating expenses while efficiently deploying resources for productive purposes. This approach ensures that the business can sustain its operations, meet short term financial obligations, and manage short term debt effectively. 

In working capital management, various financial ratios are employed to evaluate the entity’s working capital position and related aspects. 

Working Capital Ratio

One key ratio is the working capital ratio, also known as the current ratio, which assesses the entity’s ability to fulfil short term liabilities. Calculated by dividing current assets by current liabilities, a working capital ratio below one suggests insufficient cash to settle upcoming debts.  

Ratios ranging from 1.2 to 2.0 indicate efficient asset utilisation, while ratios exceeding 2.0 may indicate an overly conservative approach, with excessive short term asset retention instead of reinvestment for revenue generation. 

Average Collection Period

Another critical metric is the average collection period, which gauges how effectively the entity manages accounts receivable, impacting its working capital directly. This ratio reflects the average duration for receiving payment after a credit sale. It is computed by dividing the average total accounts receivable by the total net credit sales, then multiplying the result by the number of days in the period. 

Inventory Turnover Ratio

The inventory turnover ratio measures inventory management efficiency in meeting demand while avoiding excessive cash lock up in unsold inventory.  

This ratio indicates how many times inventory is sold and replaced during a specific period. It is calculated by dividing the cost of goods sold (COGS) by the average inventory value during the period.  

A higher ratio signifies more frequent inventory turnover, reflecting efficient inventory management practicses. 

Current Ratio and Quick Ratio in Working Capital Assessment 

In evaluating an entity’s liquidity and its capability to meet short term obligations, analysts and lenders commonly utilise two key ratios: the current ratio (also known as the working capital ratio) and the quick ratio. 

Both of these ratios not only serve to gauge an entity’s current liquidity status but also enable comparisons of its performance across different periods and against other businesses, rendering them valuable tools for lenders and investors alike. 

The quick ratio stands out from the current ratio by focusing solely on the entity’s most liquid assets, those that can swiftly be converted into cash. These assets typically include cash and cash equivalents, marketable securities, and accounts receivable.  

In contrast, the current ratio encompasses all current assets, which may encompass assets not readily convertible into cash, such as inventory. 

Due to this distinction, the quick ratio often provides a more precise indicator of the entity’s capacity to generate cash promptly when necessary. By concentrating solely on the most liquid assets, the quick ratio offers a clearer picture of the entity’s ability to meet immediate financial demands, thus serving as a critical metric for assessing short term liquidity and financial health. 

Tax payment and tax deduction planning involve strategies to minimize tax liability.

Strategies to Boost Working Capital 

Businesses often seek to increase their working capital to address various needs, such as covering project expenses or managing temporary declines in sales. Achieving this entails either augmenting current assets or reducing current liabilities, and there are several effective tactics to bridge the gap: 

Taking on Long Term Debt

By acquiring long term debt, businesses can bolster their current assets, as it injects additional cash into the entity. However, this approach doesnt excessively inflate current liabilities, as long term debts are not due within the year. 

Refinancing Short Term Debt

Converting short term debts into longer term obligations helps trim current liabilities since these debts are no longer due within the year, thereby easing immediate financial pressures. 

Selling Illiquid Assets

Selling assets with low liquidity for cash infusion can bolster current assets, providing a quick injection of liquidity into the business. 

Expense Analysis and Reduction

Thoroughly scrutinising and trimming expenses is a practical way to reduce current liabilities, thereby freeing up resources and enhancing working capital. 

Inventory Management Optimisation

Analysing and optimising inventory management processes aids in kerbing overstocking, minimising the risk of inventory write offs, and optimising working capital utilisation. 

Automation of Accounts Receivable and Payment Monitoring

Implementing automated systems for managing accounts receivable and monitoring payments can accelerate cash inflows, alleviating the need to rely heavily on working capital for day to day operations. 

These strategies offer practical approaches for businesses to enhance their working capital position, ensuring financial resilience and operational stability in the face of fluctuating business conditions. 

This article is general information only and does not provide advice to address your personal circumstances. To make an informed decision you should contact an appropriately qualified professional.