Business — Banking — Management — Marketing & Sales

Significance and Determination of Working Capital

Category: Financial Control Management

Working Capital — the most significant indicator of the Short-Term Liquidity, which is the amount of assets invested by the company in its own current operations during each operations cycle. The quantity of Working Capital reflects the share of current assets belonging to the enterprise, and at the same time it expresses the long-term financial stability and its contribution to the short-term financing equilibrium.

The formula of Working Capital is:

The formula of Working Capital

This excess is sometimes referred to as Net Working Capital because some businessmen consider current assets as Working Capital. A working capital deficiency exists when current liabilities exceed current assets.

The absolute amount of working capital has significance only when related to other variables such as Sales, Total Assets, and so forth.

The most common categories of current assets are:


Accounts and notes receivable;

Temporary investments;

Cash and cash equivalents;

Prepaid expenses.

The following are current liabilities most commonly found in practice:

Current portion of long-term debt;

Short-term bank and other loans;

Accounts and notes payable;

Tax and other expense accruals.

The analyst must undertake the «restructuring» measures of the Balance Sheet items in order to get an appropriate amount of the Working Capital, as described in Section 1.4 «Adjustments to the Financial Statements». Additionally, a range of rearrangements of the Balance Sheet components have to be undertaken:

1. Inventories have to be added up to Accounts Receivable, being termed as Realizable Assets;

2. Short-Term Investments have to be added up to Cash (cash on hand + bank accounts), being termed as Positive Treasury;

3. Owners’ Equity has to be added up to Long-Term Liabilities, being termed as Permanent Resources;

4. Short-Term Payables have to be added up to Short-Term Accruals, being termed as Current Liabilities;

5. Short-Term Financial Debt is moved downwards, being termed as Negative Treasury.

This is being done for several reasons: (1) different levels of decision making, (2) different participants and specific interests of the business participants, (3) the stability of items from each group and the particularities of transactions.

The Working Capital Equation is:

The Working Capital Equation

This equation is the basis for several important relationships, used in the Short-Term Analysis:

Negative Amount of Working Capital — represents an unfavorable financial situation, which is characterized by reduced ability of debt repayment. It is a result of absorption of a part of temporary sources by permanent needs (fixed assets), which is a violation of the financing principles.

Need of Working Capital is the difference between the financing needs for operations cycle (realizable assets) and the current liabilities:

Positive Amount of the Need of Working Capital means a surplus of realizable assets over current liabilities. It is positively appreciated only when it is a result of a thoughtful strategy directed to inventories build-up;

Negative Amount of the Need of Working Capital means a surplus of temporary resources over the need in working capital. It is positively rated only when it derives from the acceleration of realizable assets turnover financed by patient debts.

The Net Treasury (Net Credit Position) is the difference between the Positive Treasury and the Negative Treasury, i.e. between the available cash and the short-term financial debts:

The Positive Amount of the Net Treasury is characterized by a monetary surplus at the end of operations cycle, which is a material expression of the net income in the company’s bank accounts at the end of it;

The Negative Amount of Treasury reveals a financial unbalance at the end of operations cycle. The monetary deficit is off-set by newly attracted loans and other forms of short-term debt.

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