WORKING CAPITAL



Working capital is the difference between current assets and current liabilities on a company's balance sheet. Current assets include such things as cash, accounts receivable, marketable securities, inventory, and prepaid expenses. Examples of current liabilities are accounts payable, accrued expenses, and the near-term portion of loan or lease payments due. "Current" is generally defined as those assets or liabilities that will be liquidated within the course of one business cycle, typically a year.

Working capital is one measure of liquidity; creditors will often be interested in a company's working capital as one indicator of the debtor's ability to make payments on a timely basis. The components of working capital are used to calculate several financial ratios, including the current ratio, which is current assets divided by current liabilities. Banks will often write into their loan contracts covenants requiring the maintenance of prescribed levels of working capital or current ratio. The importance of these measures to credit analysts is what makes the determination of current versus noncurrent status so important on a company's balance sheet. Because of this, much thought goes into the classification of assets and liabilities.

Working capital is also of interest in the context of a business valuation, for at least two reasons. First, when using a discounted cash flow approach, the appraiser will often consider changes expected in working capital over the projected periods to convert income figures into cash flows. Second, an excess amount of working capital, particularly cash, is sometimes grounds for additional value being quantified, above and beyond that which would result from the income capitalization component of the valuation. This is because companies of a given standard industrial classification code, or industry type, are commonly thought of as requiring a certain level of working capital to operate under normal circumstances. Companies that vary significantly from the norm may be considered to have excess or inadequate working capital, and therefore warrant an adjustment.

Working capital can be provided by several sources:

  1. Net income, plus noncash expenses;
  2. Financing activities, including loans and equity infusions;
  3. Decrease in noncurrent assets, e.g., the sale of fixed assets.

Most business activities affect working capital, either consuming or generating it. Sales made at a positive margin increase working capital, as they increase one current asset (accounts receivable or cash) more than they decrease another current asset (inventory). Starting up a new product line may require higher levels of working capital, as inventory and receivables must be built up to some steady-state level. Changes in credit terms, either that the company gives on its receivables, or that it gets on its payables, will affect working capital. For example, extending more favorable credit terms to one's customers will require higher amounts of working capital, as accounts receivable will build without any compensating changes to make up the difference. The repayment of a long-term debt (bonds, capital leases, etc.) will result in a reduction, or use of working capital. This occurs as a current asset (cash) is used to reduce a noncurrent liability.

[ Christopher C. Barry ,

updated by David P. Bianco ]

FURTHER READING:

Anderson, Hershal, and others. Financial Accounting and Reporting. 4th ed. Medford, NJ: Malibu Publishing, 1995.

Anthony, Robert N., and others. Accounting: Text and Cases. 9th ed. NP: McGraw-Hill Higher Education, 1994.

Diamond, Michael A. Financial Accounting. 4th ed. Cincinnati: South-Western Publishing, 1995.

Eskew, Robert K., and Daniel L. Jensen. Financial Accounting. 5th ed. New York: McGraw-Hill, 1995.

Solomon, Lanny M., Larry M. Walther, and Richard J. Vargo. Financial Accounting. 3rd ed. New York: West Publishing, 1992.



Also read article about Working Capital from Wikipedia

User Contributions:

1
endale
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Jun 3, 2012 @ 12:12 pm
question.
True or false.A business with a higher working capital will also have a higher current ratio.(why/reason out)

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