Working Capital

Working Capital In the context of financial statements and accounting analysis, the term "working capital" refers to the difference between current assets and current liabilities. For accounting purposes, net working capital is calculated by taking the current assets shown on the left side of a firm's balance sheet (gross working capital) and subtracting the current liabilities shown on the rightside of the balance sheet. The remainder is firm's net working capital. Basically speaking, the calculation of working capital shows the net amount of capital employed in the firm which is not invested in long-term assets, like plant and equipment, but in various short-term items, like cash and inventories, required for the day-to-day operations of the firm. Aside from cash and inventories, themajor items which appear in the calculations of working capital are generally accounts receivable and accounts payable. Accounts receivable are included with current assets; they represent the dollar amount of sales billed to customers, or payment which has not been received. Accounts receivable are a measure of the firm's capital which is invested in goods and services that have been sold tocustomers on credit. As the firm's customers pay their bills the items in accounts receivable are converted into another form of current asset, cash. In an ongoing business, new amounts which are billed for sales during the current period are constantly replacing the old amounts which are paid. In most firms, accounts receivable are ever present, even though the amounts will fluctuate over time. Incontrast, accounts payable are included on the right side of the balance sheet under current liabilities; they represent the dollar amount of purchases of goods and services which have been obtained by the firm, but not yet settled. In a sense, accounts payable occur when the firm buys on credit; while accounts receivable arise when the firms sells on credit. Accounts receivable can also beconsidered as a use of the firm's capital. The firm invests capital in goods and services which it then sells on credit. Since the actual goods and services are no longer owned or held by the firm which sells them, they do not appear on the balance sheet as assets. But since the firm is owed money for the sold goods and services, it still has capital invested in an asset. Naturally, this asset should berepresented on the balance sheet, even though it is not tangible, like plant and equipment or inventory. In a similar vein, accounts payable can be regarded as a source of capital to finance the business. If a firm is investing in a piece of equipment, it can obtain money from various sources to support this investment. For instance, the firm might borrow the necessary cash from a bank to pay forthe equipment when it arrives. The balance sheet will show two entries: an increase in the amount of equipment shown on the asset side, and an increase in bank loans payable shown on the liabilities side. As another possibility, the firm might purchase the equipment on credit, perhaps paying for it 90 days after receipt. The balance sheet will show the same increase in the amount of equipment, butthe offsetting entry on the liabilities side will be an increase in accounts payable, rather than bank loans payable. In both instances, the entry on the left side of the balance sheet indicates the use of the firm's capital; while the entry on the right side shows the source of the capital, either a bank loan or a supplier credit. Although this discussion has concentrated on accounts receivableand accounts payable

up to this point, the same principles apply to other assets and liabilities in working capital calculations. For example, accrued taxes payable are directly analogous to accounts payable, except tha t they indicate the firm has not yet paid its taxes, rather than goods and services. Accrued taxes payable also represent a source of capital; until the taxes are actually...