What is Working Capital? Why is it Necessary for Businesses?

Working capital refers to the difference between a company’s current assets and current liabilities showing the liquidity strength of a company.

Here current assets include cash, accounts receivable and inventory that can be converted into cash within one year. Current liabilities refer to any obligations due within 12 months – accounts payable, wages payable and short-term debt are examples of current liabilities that must be fulfilled immediately.

Here are some specific examples of how businesses use working capital:

• To pay employees and suppliers
• To purchase inventory
• To maintain and repair equipment
• To fund marketing and advertising campaigns
• To invest in new product development
• To expand into new markets

What Does Working Capital Consist of?

Typically, working capital consists of the funds required for raw material inventory, in-process material inventory, product inventory, accounts receivable, and available cash. For evaluation purposes, working capital is generally assumed to be invested in a project at the outset of a business or industrial activity and to be fully recovered when inventories are liquidated after the project’s life.

Working capital is not deductible in the year it is incurred. Hence it frequently has a negative impact on the economics of a project. Working capital costs cannot be expensed, depreciated, amortised, or depleted until inventory assets are utilised or placed in operation.

Where is the Working Capital Spent?

Working Capital is the amount of capital necessary to develop raw materials, in-process, products, and parts and supply inventories. As stocks are depleted and products are sold, working capital cost items become deductible as operating expenses by calculating the cost of goods sold.

However, as inventory items are consumed, they are typically replenished so that inventory levels are kept at a constant level throughout the duration of the project. If large working capital increases or declines are anticipated from year to year, positive or negative working capital costs can be accounted for in project analysis.

Benefits of a Strong Working Capital Position

some of the benefits of having a healthy working capital position:

Improved financial flexibility: Businesses with strong working capital positions can better weather unexpected financial challenges, such as a downturn in sales or a disruption to their supply chain.

Increased investment opportunities: Businesses with excess working capital can invest in new growth initiatives, such as expanding into new markets or developing new products.

Improved creditworthiness: Businesses with strong working capital positions are more likely to be seen as creditworthy by lenders and investors. This can make it easier and less expensive for businesses to obtain financing.

Conclusion

In short, working capital is an essential metric for businesses of all sizes. By managing their working capital effectively, businesses can improve their financial flexibility, increase their investment opportunities, and improve their creditworthiness.