Working capital is the minimum amount of resources a company needs to cover expenses. The formula involves determining liquid assets and current liabilities to determine the current working capital requirement. It is important to calculate this regularly to spot trends that may indicate problems.
The working capital requirement is the minimum amount of resources that a company requires to effectively cover the usual costs and expenses necessary to operate the business. Since each company’s capital needs will be slightly different, there is no ideal amount of working capital that is universally applicable to all companies, or even to companies in the same industry. Even so, new businesses can develop an idea of what kind of requirements they will need to operate at given levels by researching the cost and expenses associated with other corporations engaging in similar operations.
The basic formula for determining working capital involves only two factors. First, it is necessary to define the current liquid assets that the company has. This may be somewhat different from general assets, as the focus is on those resources that can be converted to cash quickly and easily. Liquid assets can be resources such as the outstanding balance of checking accounts, property not directly used in the operation of the business, and balances in various operating accounts.
The current liabilities of the corporation must also be determined. This includes both short-term liabilities, such as regular and general monthly operating expenses, and any long-term debt. By deducting liabilities from liquid assets, it is possible to determine the current working capital requirement.
The general idea is to ensure that enough income is generated to cover the essential operations of the corporation and to allow additional income to be generated in the future. Businesses can operate with negative working capital, based on long-term debt, and this is not necessarily a sign that the business is in financial trouble. However, calculating the current working capital requirement at least once a quarter will allow the company to spot trends that may indicate problems. For example, if the requirement reveals a higher negative ratio from prior periods even though long-term debt was reduced, this may indicate a problem with declining sales, lower profits, or other factors.
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