What is working capital?

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Working capital is a financial metric that represents the difference between a company's current assets and current liabilities. It is a measure of a company's short-term liquidity and its ability to meet its short-term financial obligations.

The formula for calculating working capital is:

Working Capital = Current Assets - Current Liabilities

Current Assets include cash and other assets that are expected to be converted into cash or used up within a year, such as:

  1. Cash and Cash Equivalents: This includes cash in hand, cash in bank accounts, and short-term investments that are easily convertible to cash.
  2. Accounts Receivable: The money owed to the company by its customers for products or services provided on credit.
  3. Inventory: The goods and raw materials a company holds for production or sale.
  4. Prepaid Expenses: Payments made in advance for expenses like rent or insurance.

Current Liabilities, on the other hand, include the company's short-term obligations that need to be settled within a year, such as:

  1. Accounts Payable: The money the company owes to its suppliers for purchases made on credit.
  2. Short-Term Loans: Any loans or debts that are due within the next year.
  3. Accrued Liabilities: Unpaid expenses that have been incurred but not yet recorded, like wages, taxes, or interest.

A positive working capital indicates that the company has more current assets than current liabilities, which generally means it is in a good position to pay off its short-term debts and fund its day-to-day operations.

Conversely, a negative working capital (when current liabilities exceed current assets) could indicate potential financial trouble, as it suggests the company may struggle to meet its short-term obligations.

It's important to note that the ideal level of working capital varies depending on the industry, business model, and economic conditions. Some businesses might operate more efficiently with relatively low working capital, while others, especially those with fluctuating sales and cash flow, may need a higher working capital buffer to manage their operations smoothly.