Managing cash flow and capital is an important aspect of running a successful business. Companies need to keep enough capital on hand to meet their immediate obligations. Working capital is a strong measure of a company's liquidity. It is calculated as a company's current assets minus its current liabilities.
IMAGE SOURCE: GETTY IMAGES.
Working capital and liquidity
It's important that a company's current assets exceed its current liabilities. This means it's liquid enough to cover its short-term operating costs and debt. Current assets are those used to pay for the day-to-day expenses of running a business. They typically include cash and cash equivalents, accounts receivable, marketable securities, and inventory. Current liabilities, meanwhile, are obligations that are due within a year. Proper management of assets, cash flow, inventory, and accounts receivable can help a company retain and improve its working capital.
Working capital ratio
The working capital ratio is expressed as follows:
Current assets/current liabilities = working capital
A 2:1 ratio between current assets and current liabilities is usually considered ideal, as it's indicative that a company has sufficient liquidity to meet its short-term needs. At the same time, having too much working capital can be a bad thing, as excessive liquidity is a sign that some of those assets could -- and should -- be put to better use. Having a large sum of money in a cash account, for example, is helpful in ensuring that a company can pay its bills, but if to much cash is just sitting there earning minimal interest, it's not serving the company's best needs.
On the other hand, having too much working capital is better than having too little. If investors see that a company's working capital is consistently on the decline, they might view it as a major red flag indicating the risk that it won't be able to pay its bills. A working capital ratio of less than 1:1 is considered negative, which is a bad thing. Furthermore, companies with seasonal business models may require more working capital than companies for which business is fairly steady throughout the year. Otherwise, they run the risk of not having enough capital to cover their expenses during periods when business is slow or non-existent.
Increasing working capital
Companies can take steps to increase their working capital as needed. A business might change its collection terms on accounts receivable from 60 days to 30 days, thus reducing the amount of capital tied up in unpaid invoices at any given point in time. Similarly, a business can try extending its terms on accounts payable from 30 days to 60 days so that it can hang onto its cash for longer periods before having to part with it.
No matter what strategies a business employs, maintaining the right amount of working capital should always be a priority. Working capital is a strong measure of a company's stability and operational efficiency, so there's a lot riding on that number.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at knowledgecenter@fool.com. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.