Working capital, the capital that companies use to fund their day-to-day operations, is critical to understanding operating cash-flows. While you might think of finance as associated only with debt and equity, finance is deeply embedded in the daily operations of a business.
Working Capital = Current Assets – Current Liabilities
While working capital is a general term for the difference between current assets and current liabilities, it usually emphasizes three important components: accounts receivable, inventory, and accounts payable.
Accounts receivable: Accounts receivable are amounts that customers, typically other businesses, owe a company. The dollar amount can be reframed as a receivables collection period, which shows the average number of days it takes for customers to pay the company.
Inventory: The goods, and the associated inputs, held by a company prior to sale all count toward inventory. Based on inventory, you can generate a days inventory, which shows the average number of days that the company holds inputs and goods.
Accounts payable: The amounts a company owes to suppliers are accounts payable. Based on that, you can generate a days payable, which indicates the average number of days the company takes to pay suppliers.
A slightly narrower way to dene working capital is:
Working capital = accounts receivable + inventories − accounts payable
One simple way to think about the consequences of working capital is to note that the daily operations of a company result in an amount that needs to be financed, like any other asset. If the amount of working capital is lowered, that lowers the financing needs of a corporation. So, the way you manage working capital has deep financial consequences