Introduction

Working capital is also known as net working capital, which is a difference between a company’s current assets and current liabilities. It helps to measure the company’s liquidity and financial health, indicate the ability to fund operations, and respond to financial stress and opportunities.

Negative working capital occurs when current liabilities exceed the current assets, suggesting potential liquidity issues. Positive working capital indicates that the company can help ongoing operations and invest in future growth of the company.

High working capital is not always a good thing. It might indicate that the business holds too much inventory, is not investing in excess cash, or is not taking advantage of low-cost debt opportunities. Working capital is calculated from the assets and liabilities on the cooperative balance sheet, focusing on debt and the most liquid assets.

Calculating working capital provides insight to the company about his efficiency and liquidity. If the company has positive working capital, then it means that company can contribute to growth and expansion of the business. But if the company has negative working capital, it will face difficulties in growth, paying back to creditors, or even avoiding bankruptcy.

Formula: 

Working capital = Current assets – current liabilities

The working capital impact on Companies valuation

The working capital is a key factor in a company’s valuation because it reflects companies’ liquidity, operational efficiency and financial health. Working capital can impact a company’s valuation in a number of ways, includes:

• Excess or deficient working Capital: The working capital of the company has low or high that company required for operations can impact on valuation. Access of working capital is added to the valuation, while the deficient working capital is subtracted. If company has low working capital it will impact negatively due to that they will face difficulties in growth, paying back to creditors or even avoiding bankruptcy.

• Investment in working capital: As a company grows, they need to invest in working capital to increase their sale and revenue of the business. This reinvestment of profits reduces the cash available for distribution to owners, which will impact the company’s valuation.

• Poor working capital management: Poor working capital can lead to inefficiencies like excess of inventory, delayed in receivables, and inefficient use of cash. This inefficiency can lead to increase the operation cost and it will reduce the profitability, which will negatively impact to company’s valuation.

• Change in working Capital: the change in working capital can indicate whether the company cashflow is likely to be greater or less than its net income. Negative change in working capital means the company spending more before its revenue growth, while the positive change means the company is generating extra cash.

Working capital is calculated on the basis of company’s current assets minus current liabilities. The company having positive working capital shows that the company having high current assets comparison to current liabilities, while the company with negative working capital means the company having insufficient current assets to cover its current liabilities.

How working capital impact cashflow 

Changes in working capital are reflected in the business cash flow statement. Here are some examples of how working capital impacts cash flow:

If a transaction increases current assets and current liabilities by the same amount, then there would be no change in working capital. If the company received cash from short-term debt to be paid in 60 days, there would be an increase in the cash flow statement; however, there would be no increase in working capital because the proceeds from the loan would be a current asset and cash, and the note payable would be a current liability since it’s a short-term loan.

If the company were to purchase a fixed asset such as a building, the company’s cash flow would decrease. The company’s working capital would also decrease since the cash portion of current assets would be reduced, but the liabilities would remain unchanged because they would be long-term debts.Conversely, selling a fixed asset would boost cash flow and working capital.

Conclusion

In the present market scenario, valuations remain low and private equity firms remain cautious; therefore, efficient working capital management could be the decisive component for a successful exit and return maximization. Be a salesman either way – plan to sell your business or just want to get your house in better financial shape.

Focus on working capital management for long-term success and help you understand how to put the best strategies in place to optimize working capital and ensure a healthy boost for your company’s financial well-being.