26 Sep 2022

128

# How to Calculate Working Capital

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Working capital is a measure of a company's liquidity, efficiency, and stability. It reflects the results of the company's activities such as inventory management, revenue collection, payments and the management of debts. A positive working capital depicts the company's ability to repay short-term liabilities while negative working capital depicts the opposite ( Baños-Caballero et al., 2014). There are several of indicators that should be included in a working capital such as inventory, prepaid revenues, and deferrals.

Working capital must include inventory. The relationship between working capital and inventory is such that when the inventory increases, the working capital subsequently increases. Inventory is a set of representations of what a company owns and plans to use in the production process within a financial year. On the other hand, working capital is a result of the difference between a company’s assets and liabilities. Inventory is classified as a company’s current assets ( Baños-Caballero et al., 2014).

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Prepaid are costs that have been paid in advance. As stated, the net working capital is calculated the difference between the current assets and the current liabilities. Therefore, the net working capital is subject to change as a result of the dynamics exhibited in the current liabilities and assets over a period. Company reports include prepaid expenses as part of the current assets which is a function of the working capital. Therefore, this is enough proof that a working capital includes prepaid expenses as asserted by Etiennot et al., (2015).

Thirdly, deferrals are also included in the working capital. Deferrals are receipts for one accounting period that will be earned in future accounting periods. It is unearned revenue that has an impact on the company’s liability through reducing the working capital. The current liabilities are part and parcel of the working capital; therefore, the deferrals reduce the company's working capital. In other words, if a company possesses deferral revenue for services it intends to offer within a fiscal year, the amount is considered as a current liability and hence should be included in the working capital.

References

Baños-Caballero, S., García-Teruel, P. J., & Martínez-Solano, P. (2014). Working capital management, corporate performance, and financial constraints. Journal of Business Research ,    67 (3), 332-338.

Etiennot, H., Preve, L. A., & Sarria-Allende, V. (2015). Working capital management: an exploratory study.

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Reference

StudyBounty. (2023, September 15). How to Calculate Working Capital.
https://studybounty.com/38-how-to-calculate-working-capital-essay

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