Often confused with short-term cash requirements, working capital is an accounting instrument that measures the resources available to the company in the medium and long term to finance its current operations, excluding turnover.
Working capital is an accounting instrument that is most often calculated when a business is created, but also afterward, to better assess the financial health of a company at a time T or when it is resold.
What is working capital?
Working capital refers to all the medium and long-term resources available to a company to pay its suppliers, employees, and all of its operating expenses while waiting to be paid by its customers.
Working capital is an accounting instrument mainly used by managers to better assess the financial health of a company and, if necessary, to recapitalize it if necessary.
A formula simply defined the working capital: Working capital = Permanent capital - Fixed assets
In detail, permanent capital refers to the long-term resources of the company. These are in particular the funds provided by the entrepreneur (s) for the creation of the company (share capital), but also the uncommitted profits which increase the available resources, as well as long-term loans. This permanent capital is also called equity.
Fixed assets refer to the elements of the company's assets (tangible, intangible, financial fixed assets). All of the fixed assets represent the value of the company's working tools (business assets, patents, machinery, and equipment useful for production, right to lease, etc.).
Working capital is the difference between permanent capital and fixed assets. It thus measures the stable resources not used by the fixed assets which are used on a daily basis to cover the company's current operating expenses, before receipts.
How to calculate working capital?
As we saw above, working capital is a stable reserve of money that helps meet current operating expenses. To calculate this working capital, and during the creation, the working capital requirement necessary to start the activity, three main methods are used:
The first, the simplest, is based on the top of the balance sheet: Permanent capital - Fixed assets = Working capital
The second, more complex to implement, is based on elements at the bottom of the balance sheet: Current assets - Short-term debts = Working capital. By the name of current assets we designate the assets held by the company and intended not to remain there permanently (stocks, receivables, marketable securities), excluding positive cash which is part of the cash of the asset. .
The third, more technical still, widens the base of the elements taken into account: capital, result, debts, provisions for charges - Gross fixed assets = Working capital.
When the working capital calculation is done, three scenarios are possible: either the result is negative, or it is positive, or finally it is equal to 0.
In detail, when the working capital is negative, it means that the company is undercapitalized. Long-term money does not cover all of the investments necessary for the smooth running of the business. The weight of its fixed assets being too heavy, the company must contract equipment financing programs to finance long-term fixed assets. What about current operations? They are not financed other than by cash receipts, which is obviously dangerous for the daily life of the company! The risk of cavalry is then important. In the event of an unforeseen event, the company very quickly finds itself in a very bad position (suspension of payment, even liquidation).
When working capital equals 0, the business may have enough resources to fund its long-term investment needs, but that's it. As in the previous hypothesis, the company works without a net since it cannot cover its operating cycle without having recourse to a short-term loan, for example.
When working capital is positive , the company covers both its investments over the long term and its entire operating cycle. In this case, it has the necessary safety margin to deal with unforeseen events.
The three hypotheses of interpretation above bring out a striking feature: without sufficient long-term capital to cover investments (fixed assets) and current operating costs, a company takes risks! Hence the interest in understanding your working capital requirement right from the start.
What is the point of calculating your working capital?
Calculating your working capital allows you to know when to use business line of credit and also to have a precise idea of the financial health of your business to better ensure serene management and build your development strategy. Working capital is indeed a kind of "woolen stocking" just in case. It must be sufficient to consider a year of practice without (too many) surprises. In the event of a bad sale of a stock or the default of a customer, the company must have the means to continue its activity without having to increase its bank overdraft.
Obviously, a company does not calculate its working capital every day! Typically, this type of calculation occurs:
The creation of the company to broadly define the amount of share capital required and the amount of bank loans
At pivotal moments in the life of a company as well as upstream of the launch of a new range, in the prospect of the opening of a new point of sale or production, upstream of a significant investment in R&D or recruitment
when the business is sold, to justify its financial health and estimate the sale price as accurately as possible
An important strategic tool, the calculation of working capital makes it possible to take stock of the company's financial capacities at a given time without having to resort to bank loans. It also makes it possible to better analyze where the company's liquidity goes (Too much stock? Too much staff? Etc.).
If working capital turns out to be close to 0 or negative, the entrepreneur must know how to react as quickly as possible to raise the bar and make his business sustainable. The cause of this lack of capital is not necessarily the result of badly anticipated unforeseen events or management errors. Quite the contrary: often in young dynamic companies, the fact of moving forward by leading a booming development will lead to under-capitalization of the company. To remedy this, several solutions are available to the entrepreneur among which the addition of a new contribution in share capital, a contribution to a partner's current account, the subscription of a loan, the opening of the capital to other partners, a crowdfunding action and in some cases, the transfer of assets to third parties.