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Working capital 1.

Definition: The total capital employed of a firm is basically invested in (1) Fixed/Long term assets and (2) Working capital. Fixed/Long term assets are the assets on the balance sheet with future benefits of more than one year such as plant & machinery, building, land, etc. which are required to run the company. Working capital is the amount of money that a company has tied up in funding its day-to-day operations. A company has to tie up money to fund its stocks, credit sales and other current assets, but this is offset by its ability to fund this from current liabilities liabilities such as purchases on credit. 2. Formula Working capital = Current Assets - Current Liabilities Current Assets are the assets, which one expects to be used, or sold, within a short time period usually one year or one operating cycle. Some examples include cash, receivables, inventory, prepaid expenses, etc. Current Liabilities are the liabilities, which one expects to be settled within one year or one operating cycle. Some examples include accounts payables, unearned revenue, etc. 3. Working Capital as an Indicator Working capital is an indicator of the liquidity of the company. It is basically the ability of the company to meet up with the short-term (typically less than one year) obligations. However, quality of current assets should also be taken into account while checking the liquidity. Uncertain receivables and high inventory can often limit the capacity of working capital to judge liquidity. Also, too high an amount of working capital is a sign of inefficiency in the company. Working capital can be managed by managing the current assets such as inventories, receivables and cash and current liabilities such as accounts payable. Also the working capital requirement depends on the industry and modus operandi of the company as explained in the example below 4. Example The following example focuses on the difference between the working capital requirements of companies in various industries. Consider a manufacturing company. It requires spending cash on buying raw materials (inventories). Once the goods are manufactured it needs to stock the finished goods till it is able to sell them. After selling the goods, it needs to wait for the cash receipts from the customers (accounts receivables). Thus it needs to incur some costs before receiving the revenue (cash). Also, it can delay the payments to vendors (accounts payable). As we can infer from the above example that working capital requirements by a manufacturing company would be significant. Now consider an online retailer (say Amazon). It first gets the payments from the customer (advance), then buys the goods and ships it to the client. In such a business the working capital requirements would be less. Thus just by looking at the working capital of two companies from different industries, we can't compare their liquidity or efficiency 5. Points to Ponder:

1) Can some company have negative working capital? How would you define the financial situation of such a company? 2) A company is having high amounts of cash on its books. Is it an efficient use of resources? On what parameters would your answer depend on? What would you suggest the company?