What is working capital, its formula, turnover ratio, cycle, loan & gap?

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Working Capital is primarily an indicator of an organization’s short-term financial status and is also a measure of its overall effectiveness. 

Working Capital is derived from existing assets by subtracting the total liabilities. This ratio shows that the company has enough funds to support its short-term debt.

According to Merriam Webster (1): A company’s capital is used in its day-to-day operating activities, measured as the existing assets minus the current assets.

 

Working Capital Cycle

The Working Capital Period or WCC, means the amount of time taken by any company to turn net current liabilities and assets into cash.

  • The shorter the working capital period, the swifter will allow the company to free up its blocked cash.
  • In case, if the cycle is long, the capital gets typically stuck without earning returns in the operational period. 

 

Working Capital Formula

Working Capital

Working Capital formula is defined under:

Working Capital = Current Assets – Current Liabilities

This working capital ratio (2) is the sign of if short-term assets possessed by an organization for taking care of short-term debt.

A ratio of less than 1 is an indication of negative cash flow, while a ratio between 1.2 and 2.0 usually indicates positive/adequate working capital.

Anything that reaches two typically implies that the organization does not spend surplus assets and thus reflects lost opportunities.

 

Working Capital Turnover Ratio

Working capital turnover is a measure that calculates how effectively a company uses its working capital to sustain a given revenue level.

 

The formula for Working Capital Turnover

Working Capital Turnover can be written as Annual Net Sales of an Organisation over the Average Working Capital of the Organisation.

Work capital turnover also refers to as net revenue to working capital, demonstrates the correlation between both the funds used to finance the activities of a business and the resulting revenues created by a company.

Mathematically, 

Working Capital Turnover = Net Annual Sales​​/Average Working Capital

 

What Working Capital Turnover say to you

The ratio of working capital turnover is determined by dividing net annual sales for the same 12-month period by the average sum of working capital – current assets minus current liabilities.

  • high turnover ratio means that management is very successful in using the short-term assets and liabilities of a business to sustain sales.
  • low turnover ratio may mean that a company invests in too many receivable accounts and stocks to sustain its revenues, which could lead to unsustainable amounts of bad debts or obsolete inventories.

 

What’s a Working Capital Loan?

A loan that is taken to fund the daily operations of a business is known as Working Capital Loan. Such loans aren’t used to purchase long-term assets or investments and rather are used to provide the working capital that meets the short-term financial needs of a business.

These needs can include costs such as:

  • Rents
  • Payroll
  • Debt Payments

Hence, the working capital loans are just corporate debt borrowings that are managed by a company to support its daily operations.

 

Working Capital Loan Working

Anyhow, sometimes, a firm does not have a sufficient amount of cash in hand or asset liquidity so that they can cover every day’s expenses and, thus, a company acquires a loan for this purpose.

  • Most businesses have a year-round shortage of reliable or predictable sales.
  • Manufacturers usually perform much of their manufacturing operation during the summer months to supply retailers with the correct amount of products, having inventories ready for the fourth-quarter push.
  • Retailers also decrease manufacturing purchases at the end of the year arrives as they concentrate on selling out their inventory, which ultimately minimizes the manufacturing sales.
  • Businesses with this type of seasonality often want a working capital loan to pay wages and other operating expenses(2) during the quiet period of the fourth quarter.

The loan is usually paid by the time the organization hits its hectic season and no longer in need of the financing.

IMPORTANT NOTE: Missed payments on a work capital loan will affect the credit score of the business owner if the loan is attached to their personal credit.

 

Working Capital Gap

In plain terms, the working capital deficit is the difference between total liquid assets and total equity other than bank liabilities.

It can also be described as Long term sources few long term uses.

Working Capital Gap

It can be shown as:

Current assets minus current liabilities are equal to the Working capital gap.

Current assets – current liabilities

 

Is it an excellent strategy to have a substantial amount of working capital?

working capital

Not necessarily. When you consider the contingency cash of a company in its reserves under the working capital formula, a large sum of working capital is a strong indication that the company would be able to cover its payables and other short-term obligations financially, even though the business will unexpectedly dry up.

Nevertheless, if in the portion of the current assets of the working capital calculation you are using only the cash required by a 

company for “day-to-day” operations, then a large amount of working capital with a relatively small amount of money may mean problems.

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Sudhanshu is a solemn soul of open mind and intangible thought with some skills in writing and calisthenics.

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