Working capital is the amount of money a firm has available, to pay its bills each day. Working capital does not include money used to buy fixed assets (machinery and equipment). Money used to buy fixed assets is called capital expenditure.
This diagram explains how to calculate the working capital for a business
What is Working Capital Used For?
Working capital is used to pay for things like:
Stock
Materials
Wages/Salaries
Telephone Bills
Heating Bills
Water Bills
Business Rates
Broadband
Rent Payments
Why Is Liquidity Important
Businesses need to ensure that they have enough money or liquidity to pay for their daily bills. If a business does not have sufficient liquidity it may face eviction, utilities being cut off, no stock and loss of reputation or worse still closure. Businesses can be making a profit but still be forced to close if they do not have enough money to cover their daily activities and bills.
How Do You Calculate Working Capital?
Working capital is the difference between the money your business has and the amount of money it has to pay.
Working Capital = Current Assets - Current Liabilities
When people are analysing the financial strength of a firm they may review working capital ratios to assess how much working capital is available for every dollar/pound of liabilities (bills). Remember what a "healthy" working capital ratio is will vary by industry.
Once a business knows what its working capital is, it can plan how to deal with it. If a business does not have enough money to cover its bills (ie a working capital deficit) it may apply for a loan to cover the deficit especially if it feels that it will generate enough money to cover the loan repayment. However if a business knows that it is unlikely to cover the deficit in the future it may decide to stop trading.
