Financial Accounting Concepts

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

Working capital is the money that a company requires for day-to-day needs to fund the daily operating activities, and in general:

Working Capital = Current Assets – Current Liabilities

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 material, in-process, product, 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.

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