Working Capital Calculation

All the subjects related to establishing the financial position of the business like accounts, costing and financial management have something or the other to do with what is known as working capital.

Calculating Working Capital

Before I get to the part about how working capital can be calculated, it is essential to define a couple of terms who have quite a bit to do with the calculation.

Current Assets
Another little something we hear a lot but don't know the meaning of. The definition of current assets is indeed quite ambiguous and contextual. Current assets are generally those assets which can be liquidated quickly or whenever you need them liquidated. While this seems fairly straightforward, the ambiguity revolves around the word 'quickly'. How quickly is quickly? Different answers are given by different companies in different industries. But the general assumption is that when you look to the assets side of the balance sheet, certain items like cash-in-hand, cash at bank, marketable securities and working inventory and debtors (again, debatable) make the grade as current assets.

Current Liabilities
The definition of current liabilities, in contrast, is fairly simple. Current liabilities are those liabilities that might have to be paid any time soon. The payment date for current liabilities is not fixed and the debt might mature anytime. But then again, a long term loan is not and never will be a current liability, even if it has to be paid off tomorrow. Current liabilities are simply those liabilities which you might have to pay up for anytime. So typically current liabilities is the sum of the amount owed to creditors and, sometimes, bills payable.

Working Capital Basics
So great, we learned 2 new terms today. But how is this going to help you in finding out the working capital? Well you'll be pretty glad to know that once you've wrapped your heads around what current assets and current liabilities are, calculating working capital becomes a piece of cake, like so:

Working Capital = Current Assets - Current Liabilities

See? That simple. Oh yes, and the fact that I put the current assets first in the formula means that the working capital ought to be positive i.e. the total of the current assets should be more, often twice as much for the sake of unforeseen risk factors, the total of the current liabilities.

Change in Working Capital Calculation and Its Importance

Now that you had to go through the fairly difficult steps to learn about working capital, I believe you deserve to know more about it. After all, people who do know what working capital is do tend to make a big fuss about working capital? What's the big deal about it anyway? Why is there a whole subject called 'working capital management' devoted to it?

Hard enough to surmise, but this little amount, which hardly involves 4-5 balance sheet items, with usually the lowest amounts in the whole sheet, could make your bankrupt or at least, lead to short term debt settlement problems. How? Because if your current liabilities exceed the assets, and you run into your creditors, the business might find itself in a real fix. Secondly, the working capital shows the efficiency in running the business. A low capital generally indicates that your debtors pay you slowly (your collections are low), while your creditors are a lot more demanding. One more unhealthy looking scenario.

So this was all about calculating working capital. As you can see, it is very easy to find out and yet, is very important. So it's not a topic you want to ignore!