Importance of Working Capital
Definition: An organization’s current assets; the assets available to run the organization in the short term.
Working capital is important because it is the catalyst that makes fixed and long-term assets productive. For instance, although fixed and long-term assets consist of buildings and equipment, the building and equipment cannot be productive or produce revenue unless working capital in the form of employee and inventory is introduced.
The cost of the employees and inventory, as well as the costs of the building and equipment in the form of depreciation, are reflected in the bill to the client. Until the bill is paid, the amount is carried as an account receivable, when the bill is paid, part of the money is used to start the process again.
Current assets include Cash, short – term securities, account receivable, inventories & prepaid expenses.
Current assets are often measured in terms of their liquidity, which is their ability to be consumed or converted to cash.
Liquidity: A characteristic of an investment that pertains to how quickly it can be converted to cash.
Net working capital: Although working capital is the organizations total current assets, net working capital is the difference between current assets and current liabilities.
Sources of Working capital:
Sources of working capital include money invested in the organization (equity), net income, borrowed money (which is an increase in noncurrent liabilities), and the sale of a noncurrent asset, such as a building or piece of equipment. The sources and methods used to finance working capital, as well as the quantity of working capital to be maintained, make up what is called the working capital policy.
Financing Temporary Working Capital Needs:
Assuming that the organization does not have sufficient cash available to meet temporary working capital needs, two sources of short term financing are available: debt & trade credit.