What is working capital?
Working capital is the difference between a company’s current assets (cash, stock, debtors and raw materials) and current liabilities (creditors). The working capital, also referred to as net working capital, defines a company’s short-term financial health. When a company has substantial working capital, then, it has the potential to grow and expand its operations.
What is the formula to calculate working capital?
The formula for working capital is: current asset – current liabilities.
For e.g., If a company has a current asset of Rs 1,00,000 and a current liability of Rs 20,000, then:
Working capital = Current asset – Current liabilities
So, Working capital = Rs 1,00,000 – Rs 20,000 = Rs 80,000
See also: All about Indian accounting standards (Ind AS)
What are the things that come under current assets and current liabilities?
| Current assets | Current liabilities |
| Cash at hand | Creditors |
| Cash at bank | Accrued expenses |
| Stocks | |
| Debtors | |
| Prepaid expenses |
Also read: What is depreciation?
Example of working capital calculation
If your business has current assets such as:
- Debtors: Rs 2,00,000
- Stock: Rs 2,00,000
- Cash at hand: Rs 1,50,000
- Raw material in warehouse: Rs 40,000
- Prepaid expenses: Rs 50,000
The total current assets of the company amount to Rs 6,40,000.
If your business has current liabilities such as:
- Creditors: Rs 1,70,000
- Accrued expenses: Rs 80,000
The total current liabilities of the company amount to Rs 2,50,000.
The working capital of this company would be:
Current Assets – Current liabilities = Rs 6,40,000 – Rs 2,50,000 = Rs 3,90,000
Also read: Cost accounting meaning and types explained
Limitations of working capital
Although working capital can be useful in ascertaining a company’s short-term health, it has several limitations:
- Working capital is always changing. Hence, by the time financial information is calculated, the working capital of the company may have changed.
- Working capital does not consider the underlying types of accounts. For example, if a company has 100% of its current assets in accounts receivable, although the working capital will show as positive, its financial health will depend on whether the payments are realised.
- The value of a company’s assets can change quickly, based on forces outside its control. Therefore, the working capital will also change accordingly.
- Working capital is calculated on the assumption that all debts are known, which may not be the case.
See also: What is Cash book in accounting ?
