Working capital and liquidity are two key terms from a business perspective and are related to each other. A company’s working capital measures the liquidity and the overall health of the company to meet its short term obligations.
Cash is the lifeblood of business that is needed for the day to day operations. Effective management or operation of working capital is a prerequisite for success. Now let’s take a look at the definition of Working Capital.
What is Working Capital?
Working capital is the funds available to the company to sustain its daily operations. It is essential for the core day to day activities of a business. Factors that determine the working capital requirements include the inventory requirements, the accounts payable, and accounts receivable, among a few.
Working Capital = Current Assets – Current Liabilities.
A positive working capital shows that the company can meet short term liabilities. It depends on how quickly you receive payments and the rate at which you make the payments to your suppliers.
A company will have a higher working capital if they receive the payments from their customers fast. But in most cases, customers purchase the goods on credit and pay the amount at a later stage.
The credit period varies from customer to customer. It could be 30, 60, and 90 even more, depending upon the customer. To maintain the cash flow of the company factoring services can be utilized. Working capital also increases with a high growth rate and the ability to increase profitability.
What are the components of Working capital?
Current assets and current liabilities are the two crucial components of working capital. Cash and other resources that can be converted into cash or will be used in a year are current assets. Whereas, current liabilities are the company’s obligations that are to be paid within the year.
Examples of current assets include cash, cash equivalents, accounts receivable, inventory, marketable securities, and prepaid expenses to, name a few.
Examples of current liabilities include accounts payable, wages, short term debt, and dividends to, name a few,
Calculation of Working Capital Ratio
The working capital ratio is a measure of liquidity or another way to compare a company’s current assets to its current liabilities. It directly expresses the relationship between your company’s short-term assets and liabilities. The higher the ratio, the better the position of the company,
Working Capital Ratio = Current Assets / Current Liabilities.
What is Liquidity?
Having the money to pay the obligations when they are due. In other words, liquidity is the ability to convert its current assets into cash to meet its current liabilities when they are due.
In most companies’ balance sheets, current assets are listed on the assets side in terms of their liquidity starting, with cash. Any failure to pay any obligations will have a hit on the credit rating. Therefore, it will act as a red flag for suppliers to extend credit for the company.
Calculation of Quick ratio
The quick ratio is also known as the acid test ratio. It allows you to have an understanding of the liquidity position of the company. A company that sells goods always has the risk of not converting its stock into cash. Without cash, a business would not be able to meet its operating expenses. Therefore we exclude inventory and any prepaid expenses while calculating the quick ratio.
Quick Ratio = (Current Assets – Inventories – Prepaid expenses) / Current Liabilities
Is there any difference between Working Capital and Liquidity?
Yes, working capital and liquidity are two related terms. But they don’t convey the same meaning. Having a ton of slow-moving inventory will increase your current assets but not your liquidity.
Hence, for the smooth running of an organization, the business must find a perfect balance between both.