The What's and Why's of Working Capital

Working capital is essentially the short term capital that is at work for the company. Net working capital is usually calculated as accounts receivable plus short term assets minus accounts payable plus any short term liabilities. Neither cash nor interest bearing capital is included in calculating working capital.

Calculations

Working capital calculations are used by company analysts to measure the solvency of the corporation. If it is a publicly traded stock, a measure of the working capital can help analysts predict if the company will be capable of offering a dividend or increase its dividends to investors if that should be a financially efficient strategy for the firm. One highly followed statistic is the company's current ratio this is current assets divided by current liabilities. A ratio of at least one or above shows a company that is solvent. Conversely, a ratio below one means that sooner or later at this rate with low balances of cash the company will eventually have to open lines of credit or shrink the balance sheet in order to finance the overall balance sheet. Another similar measure of short-term solvency is the acid test which is cash, marketable securities, and net receivables divided by current liabilities.

Working Capital Management

Imagine when the company  decides it's going to make new acquisitions or expand its inventory. This requires a level of planning to the company. Net working capital will allow the company to simply make these acquisitions.

Also, consider when the company wants to buy a piece of machinery that is very expensive. Chances are that the piece of machinery cannot be easily balanced with the net working capital. This acquisition will sink the company's solvency. Therefore, working capital management is very important to make sure that short term financed acquisitions are feasible.

Short-Term Financing

The financing for short term acquisitions can be classified into 2 groups: unsecured debt and secured debt. Essentially, the main difference between the two categories is the secured loans require collateral in order to make the financing possible. Unsecured loans include commercial paper and bank loans. An example of a secured loan from the bank is when the company pledges some of its assets such as accounts receivable or its inventory to securitize the financing for the loan. Banks prefer this so when the company defaults they have something to liquidate in order to make whole on the loan. What's more, the interest rate charged for the loan will go down with the pledged collateral.

The long term acquisitions should not make the balance sheet go out of whack. This means that companies have to plan in order to stay solvent. One techniques that can be used for working capital management to be effective is hedging.

Hedging

Basically hedging involves matching the cash flow with the maturity of the bank loan or whatever source of financing the company is using, such as the secured loan or commercial paper. This principle is basic, but when the company has to worry about their solvency it helps.

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