What is Working Capital?
Working capital is the difference between a company's current assets and its current liabilities. Current assets are assets that are expected to be converted into cash within one year, such as cash, accounts receivable, and inventory. Current liabilities are obligations that are due within one year, such as accounts payable and short-term debt.
The formula is: Working Capital = Current Assets - Current Liabilities
Interpreting Working Capital
Positive working capital indicates that a company has enough short-term assets to cover its short-term liabilities. Negative working capital, on the other hand, can be a sign of financial distress. However, the ideal level of working capital varies by industry. A company with a very predictable cash flow may be able to operate with a lower level of working capital.
The Cash Conversion Cycle
Effective working capital management involves managing the cash conversion cycle (CCC). The CCC is the length of time it takes for a company to convert its investments in inventory and other resources into cash. A shorter cash conversion cycle is generally better, as it means the company needs less time to generate cash. This involves efficiently managing inventory, collecting accounts receivable quickly, and optimizing payment terms with suppliers.
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