Do you want to know how to calculate the working capital of an organization? This story gives a step-by-step solution. Have a look...
Working capital is the difference between the current assets or the short-term assets that a company holds and the current liabilities or the short-term liabilities which the company has to dispose of. Thus, working capital actually depicts the financial health of the company in a short period.
It shows whether a company has enough finances or assets to take care of any short-term liabilities that may arise. Calculation of the working capital is done after calculating both the current assets and liabilities. It is very important to know what is included while arriving at the current assets and liabilities figure.
Here is the explanation along with a simple example for your reference.
Current Assets and Liabilities
Assets of a company are of two types―long-term assets and short-term assets. Short-term assets, also known as current assets, are those which will either be used or sold within one operating cycle, usually one year.
Current assets are calculated as the sum total of the cash or cash equivalents, current inventory, accounts receivable, as well as marketable securities.
Liabilities of a company are of two types―long-term liabilities and short-term liabilities. Short-term liabilities, also known as current liabilities, are those debts, obligations, and liabilities of a business which have to be settled within one operating cycle, usually one year.
Current liabilities are calculated as the sum total of the accrued expenses, accounts payable, part of the long-term debt which is accounted as current and notes payable.
Formula Working Capital = Current Assets (Cash + Current Inventory + Accounts Receivable + Marketable Securities) - (Accrued Expenses + Accounts Payable + Current Debt)
Example Let's take an example of a company named YXM Ltd. YXM has cash worth $200,000, $20,000 in account receivable, $100,000 in securities, and $40,000 in inventory. The same company has $80,000 in accounts payable, $40,000 in current debt, and $30,000 in accrued expenses. How will its working capital be calculated?
Current Assets of YXM Ltd. = $200,000 + $20,000 + $100,000 + $40,000 = $360,000
Current Liabilities of YXM Ltd. = $80,000 + $40,000 + $30,000 = $150,000
Thus, Working Capital of YXM Ltd. = $360,000 - $150,000 = $210,000
Suppose the working capital of YXM Ltd. in the previous year was $200,000, then, for change in the working capital calculation, the working capital of the previous year is subtracted from that of the current year. For YXM Ltd, change in working capital will be $210,000 - $200,000 = $10,000.
A positive working capital is a good sign for the business, as investors base their investment decisions on the liquidity of a company, which is reflected when the current assets are more than current liabilities in a given period.
A negative working capital, on the other hand, implies that the business is unable to pay off its short-term debts, and hence, may suffer from losses and bankruptcy over time.
A negative working capital also indicates that the company is not being run efficiently or that its sales are falling. Thus, by calculating the working capital, a business's shortcomings can be brought out, and the required corrective actions can be taken.