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Working capital

Working capital is current assets less current liabilities and is a measure of a company's ability to finance its current operations. It can be positive or negative depending on a company's level of debts. The higher the working capital, the more likely it is to expand its operations. A company experiences a working capital deficit when its current assets are less than its current liabilities and is not likely to grow.  

As costs and operating expenses are recurring items, a company need to maintain a sufficient amount of working capital to pay them. The working capital required for each company varies as it depends on the levels and frequency of their earnings and the differences of expenses and how high they are incurred.

A company having a large excess of current assets over current liabilities is not necessarily in a better position to finance its operations. The important factor is the liquidity of its current assets. Liquidity means these assets can be readily converted into cash to run the daily operations of the company. Competent management of these assets which are stock, debtors and cash in hand and at bank is therefore of immense importance in order to maintain a healthy working capital. For example, there must be a high turnover of stock items and efficient collection of debts from the debtors.

To be able to meet short-term debts, working capital may be sourced from net income, long-term and not short-term loans which add to the current liabilities, sale of capital goods, and introduction of additional capital by the owners or stockholders. A very satisfactory working capital enables the company not only to expand but also to innovate, and enhances its eligibility to obtain external loans and favourable credit terms from suppliers.

One can inspect a company's balance sheet to find out its working capital. It reveals how much or none is left when the current liabilities are deducted from its current assets and thus the ability or inability of the company to pay off its short-term debts. A company whose current liabilities are in excess of its current assets runs the risk of not being able to pay back its creditors and faces the prospect of liquidation. This could be the result of the company suffering declining sales which in turn reduces the overall amount collectible from the debtors besides the slow clearance of stock and settlement of debts by the debtors.

A small business or a large conglomerate possessing multi-million dollar assets faces the same risk of bankruptcy if it is unable to meet its short-term debts such as the monthly bills which have to be paid. Its insufficient or negative working capital causes it to increase borrowing and defer payments to creditors with the resultant fall in its credit rating. A low credit rating increases its burden of debt servicing due to increased interest in borrowing. This serves only to worsen an already difficult situation of the company