Working capital is an effective measure of a company’s underlying operational efficiency and its short-term financial health. It is calculated as current assets less current liabilities. If the resulting figure is positive, this is an indication that the company is able to pay off its short-term liabilities. Negative working capital means a company is in more precarious financial health, unable to meet short-term liabilities with current assets, such as cash, accounts receivable, and inventory. Clearly, if the value of a company’s current assets are less than its current liabilities then it may face difficulties paying back creditors. It may even be forced into receivership.
Potential investors and lenders will be alarmed by a declining working capital ratio as this could be an early warning sign of more serious problems, such as falling sales volumes, which will ultimately result in falling profits.
Even firms that are asset-rich and profitable may be short of liquidity. This may be the case where their assets cannot easily be converted to cash. In such circumstances, companies may find themselves lacking the working capital they need to fund maturing short-term debt, continuing operational expenses, or expansion.Best Practice
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- Financial Management
- Financial Management: An Introduction
- Financial Management for the Small Business