Putting mathematics in words, working capital is entity’s investment in current assets. Usually we use working capital as a measure to determine entity’s ability to coup efficiently with its liabilities.
Most of the time this term is used to mean net working capital which is expressed as: current assets – current liabilities. But remember net working capital is different from working capital and is not one and the same thing.
Cash is generated by selling units or services. Non-current assets and other similar long term investments cannot produce anything on their own that can be sold and that is why they have to be fed with current assets like raw materials. Raw materials are processed by applying labour and overheads on raw materials to convert them to finished goods and then finished goods are sold to earn revenue. In short raw materials help entity to drive cash flows and works as life line.
However, not all sales are on cash basis. To support revenue generation and to grow sales, goods are also sold on credit basis. These debtors are in essence a form of short term investment. Allowing credit facility to customers attracts more customers and thus results in increased sales. In short, credit facility to customers is helping entity to generate more sales and thus is also considered an investment made by the entity and added up as part of current assets.
But we also know that not all of the stock that entity buys is on cash basis. Mostly it is on credit basis from the suppliers. Although it is a liability and entity will have to pay for the goods bought but it is helping entity in two ways.
- entity is able to afford raw material which it can convert to earn revenue
- payment is not upfront and thus the same money can be used in other investment opportunities
In simple words, goods offered by suppliers on credits basis is an indirect loan to us that helps us increase the revenue or cash flows of the entity as they are helping finance current assets which are ultimately generating cash flows for organization.
And thus current liabilities are also part of working capital. But as entity has to pay for such obligations we have to deduct them from current assets if we like to calculate net working capital.
As you can see how important it is for any entity to survive with such investments. If such capital is missing then even with loads of non-current assets and human resource at disposal, entity will not make even a penny. That is the reason working capital is used to determine entity’s ability to generate cash flows. And cash flow generation ultimately help predict entity’s capability to pay its liabilities on time. No cash inflows results in low cash which results in liabilities piling up which may end up in entity’s bankruptcy.
To sum it up, working capital are those short term investments that helps entity drive forward and make actual business to run and breath.