What is the correct definition of Working Capital?

How do we define Working Capital (WC)?

The common response to this question is WC is the money needed to run day to day operations of the firm. Calculated as Current Assets minus Current Liabilities (CA-CL).

Before we begin our discussion, first of all – apologies. Due to some unforeseen circumstances, our newsletter for this week is delayed. We will be back to our Friday cycle in the coming week.

 

Let’s defined Working Capital

Now think – if a Company has CA = CL = Rs 100 million, does it not need any money to run day to day operations?

Have we thought why do we use CA-CL as the formula for calculating WC. If it is money needed to run day to day operations, why don’t we use some measure of expenses (like total expenses / 365 for example)

There is something missing in the above definition. It is key to understanding how WC is interpreted.

If I have high receivables or inventory, capital is blocked in these assets.

The right way to interpret WC would be to view it as amount Blocked in short term assets, which could have been used elsewhere. In other words, the above definition needs to be modified to

WC is the money needed
“to be FUNDED in order to run day to day operations of the firm smoothly”, or
“to FUND the amount blocked in Short Term Assets”

How do you fund this amount? By Current Liabilities – like payables or Short Term Loans. Or by Using Cash.

Now if CA = CL = 100 million, then WC = 0.
This means, I do not need to FUND anything to run my business. I have already funded the amount blocked in CA by using CL.

This is key, since rising WC usually is bad for the company. It means more funds blocked.

Negative WC is preferable from the shareholders’ point of view, unless it impedes demand in the long run.

Food for thought – How do you interpret Current Ratio with this information?

 

Do write back to us with your thoughts.