Balance sheet of a business or company consists of assets, liabilities and stockholder’s equity. Working capital for a particular period represents the difference between current assets and current liabilities for that particular period. Working capital will determine the capacity of a business to pay off its current liabilities with current asset or cash and assets available to fund company’s day to day operation.
Working Capital = Current asset – Current Liabilities
Current asset means those assets which expect to turn into cash within one year or one business cycle whichever is less. For example; cash, inventory, prepaid expenses, securities, debtors and cash equivalents are considered as current asset.
Current liabilities represent those liabilities which are expected to be paid within one year or one business cycle. Example includes creditors, accrued income tax, dividends payable, salary payable, and other liabilities.
Both current asset and current liabilities are balance sheet items.
For instance, if a company has Rs. 50000 of current assets and current liabilities of Rs. 25000, working capital of the company in this case would be Rs 25, 000(Rs. 50, 000 – Rs. 25, 000).
This means company would be able to pay all of its current liabilities out of current asset and would leave with a surplus of Rs 25, 000.
If the company has current liabilities of Rs. 25, 000 and Rs. 50, 000 of current assets then it has a working capital deficit of Rs 25, 000 which has to be funded either by selling long term assets or through some other source like bank finance.
Net working capital is presented as a Rupees amount and can be positive or negative. Positive indicates that the company will be able to pay off its short-term liabilities almost immediately. Negative indicates that the company will not be able to pay off its liabilities with current assets.
Decrease in working capital compare to last year means the company is becoming overleveraged, paying its current liabilities too quickly, collection from debtors
Company must track all part of working capital to maintain the right level. Grocery stores or companies that do business on a cash basis need very little working capital to run the business. However, companies responsible for manufacturing auto and heavy machineries are required to have enough working capital to fund their day to day business as they cannot raise cash quickly as a grocery shop.