Importance of Working Capital for an Investor
Published by Sharekhan Education | January 2, 2021
Importance of Working Capital for an Investor
Working capital is the lifeblood of a business. It is the money that a company needs to meet its current and short-term obligations. It is a measure of a company’s efficiency in allocating its resources wisely and also indicates its short-term financial health. Calculation of working capital is as follows:
Working Capital = Current Assets–Current Liabilities
Current Assets:
They are cash, along with other assets that you expect to turn into cash within a year. Current assets include accounts receivables, inventories (pending collections on invoices), marketable securities, short-term loans, and advances (money given to the third party either as a loan or as an advance for delivery of purchased products), and cash and bank balance.
Current Liabilities:
They are any bills and other financial obligations that are due for payment within a year. Example for current liability includes trade payables, provisions, other current liabilities and short-term borrowings. Trade payables are the monies to be paid to suppliers. Provisions are the amounts to be kept aside for obligations such as dividend payment, employee benefits, sales, excise tax-related issues, etc. Other current liabilities are advances from customers, statutory liabilities like GST, current maturity of long-term debt, current maturity of lease liability, unclaimed dividend, unclaimed interest, just to name a few.
Usually, the short-term borrowings (unsecured loans) are excluded from current Liabilities and clubbed with the long-term borrowings before calculating the working capital.
Let’s take an example to understand this concept.
| Working Capital (Rs. Crs) | Company A (Rs. Crs) | Company B (Rs Crs) |
| Inventories | 100 | 100 |
| Cash and Bank balance | 5 | 5 |
| Loans and advances | 10 | 10 |
| Trade receivables | 120 | 100 |
| Other current assets | 20 | 20 |
| Total Current Assets | 255 | 235 |
| Trade payables | 80 | 100 |
| Provisions | 20 | 20 |
| Other current liabilities | 150 | 150 |
| Total Current liabilities | 250 | 270 |
| Working capital | 5 | -35 |
Positive Working Capital:
In the example above, positive working capital means that the company can pay off its short-term liabilities with its current assets. It is a desirable situation for the company, and the company will not incur a lot of short-term borrowings.
Positive working capital can be due to various reasons. It could be due to high inventories, high trade receivables, or high loans and advances. During an expansionary economic phase, this is not an issue. But, in the event of a recession, inventories and money collected from customers and third parties would move at a much slower pace. Hence a high current asset compared to a high current liability can be an issue during such an event. High current assets on the back of excess cash are also not very preferable. It signals that the company is unable to deploy its cash to generate higher returns.
Negative Working Capital:
In the example above, negative working capital indicates the company can’t cover short-term debts with current assets. This is usually not a desirable situation, as it indicates that the company might struggle without borrowing. Assuming that a company is a going concern, negative working capital should not always raise a red flag, provided it is due to higher trade payables. Higher trade payables generally mean that the company is paying its suppliers late. It indicates a high bargaining power of the company as compared to its suppliers. Negative working capital on account of high provisions and other current liabilities is not the best situation. These liabilities could be related to the maturity of short-term borrowings, statutory liabilities like GST, payment to employees. In such an event, the company cannot delay the payments that are due. Hence, it would eventually face a liquidity crunch. It can also lead to high short-term borrowing.
Some of the ways how a company can improve its working capital position are:
- Maintain lower collection days for receivables and higher days to pay is suppliers.
- Efficiently manage inventories and,
- Refinance its short-term debt obligation with a lower rate of interest.
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