Working Capital- Its Importance in a Business

Definition

Working capital is the difference between a company’s current assets and current liabilities. This is the simplest meaning of working capital. Current assets of a company are the assets which can be easily converted to cash in a period of one year and current liabilities of a company are the obligations or debts of a company which is due within one year. These two are the most important part of the company’s financial statement called the Balance sheet. Just like their presence is important and evitable their role in the organization’s working is also important.

Current assets can be cash, equivalent to cash, customers unpaid bills or nay cash forms and current liabilities can be accounts payable which means the amount of cash due to any source which connects with the company’s working.

Thus we derive the basic formula to calculate working capital as the subtraction of current liabilities from current assets.

Important features of working Capital:

A company is judged by third parties based on its working capital position whether it is profit making or loss-making and its general financial health. Some points which are essential to it are :

  1. Measures the functional efficiency and strength of a company in financial terms.
  2. A healthy company with a positive working capital situation will be represented in the ratio form of 1.2 till 2. This is called the current ratio
  3. Having more of current assets so that the obligations can be repaid effectively and timely.
  4. The company should be preventive of working capital that may be a negative value at all time an ensure safety of its assets.
  5. Also, a company should avoid a high working capital which is an indication that the company doesn’t fully use the assets to generate revenue.

Need for working capital:

The company needs working capital in a positive ratio due to some very specific reasons which can be :

  • It is essential to have a good working capital ratio to avoid the business from facing financial insolvency, legal problems and from the liquidation of its assets.
  • A good working capital ration enables the business to sustain as well boost their earnings.
  • Having current assets in a higher amount will result in better profits and ensure a long life for the business.
  • Working capital management must be done in order to frequently monitor the position of a company’s assets and liabilities.

Thus the business growth and its long-term sustainability are based upon the working capital position of it and how it has been regulated.