Question

Explain what working capital is and why it is important for a business As an example, describe a business that operates where you live and describe how knowing what the working capital of that company would be useful to the business leaders of that company and to outside investors.

Answer 1

In accounting term working capital is the difference between current assets and current liabilities. If we break down the components of working capital we will find working capital as follows:

Working Capital = Current Assets – Current Liabilities

Maintaining adequate working capital is not just important in the short-term. Sufficient liquidity must be maintained in order to ensure the survival of the business in the long-term as well. The various reasons for the poor performance of public sector undertakings in any country has been the large amount of funds locked up in working capital. This results in over capitalization. Over capitalization implies that a company has too large funds for its requirements, resulting in a low rate of return, a situation which implies a less than optimal use of resources. A firm, therefore, has to be very careful in estimating its working capital requirements. We can say that a firm should neither have too high an amount of working capital nor should the same be too low. It is the job of the finance manager to estimate the requirements of working capital carefully and determine the optimum level of investment in working capital.

For example, in a local stationery product manufacturing factory, business leaders and outside investors need to have the working capital related information because:

1. A large amount of working capital would mean that the business has idle funds. Since funds have a cost, the company has to pay huge amount as interest on such funds.

2. If the firm has inadequate working capital, such firm runs the risk of insolvency.

3. If a company’s current assets do not exceed its current liabilities, then it may run into trouble with creditors that want their money quickly.

4. Paucity of working capital may lead to a situation where the firm may not be able to meet its liabilities.