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Introduction to Working Capital
Overview of the Working Capital Financing Decision
Finance Textbooks Boundless Finance Introduction to Working Capital Overview of the Working Capital Financing Decision
Finance Textbooks Boundless Finance Introduction to Working Capital
Finance Textbooks Boundless Finance
Finance Textbooks
Finance
Concept Version 8
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Calculating Expected Value

The main accounts which affect the value of working capital are accounts receivable, inventory, and accounts payable.

Learning Objective

  • Calculate a company's working capital


Key Points

    • Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses.
    • The management of working capital involves managing inventories, accounts receivable and payable, and cash.
    • Current assets and current liabilities include three accounts which are of special importance: accounts receivable, inventory, and accounts payable.
    • Working capital is equal to accounts receivable plus the value of inventory, minus accounts payable.

Terms

  • M&A

    Mergers and acquisitions (M&A) are aspects of corporate strategy, corporate finance, and management dealing with the buying, selling, dividing, and combining of different companies and similar entities that can help an enterprise grow rapidly in its sector or location of origin, or a new field or new location, without creating a subsidiary, other child entity or using a joint venture.

  • balance sheet

    A summary of a person's or organization's assets, liabilities and equity as of a specific date.


Full Text

Working capital (WC) is a financial metric which represents operating liquidity available to a business, organization, or other entity - including a governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques, such as DCFs (Discounted Cash Flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a "working capital deficit. "

A company can be endowed with assets and profitability but short on liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

Calculation

Current assets and current liabilities include three accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

  • accounts receivable (current asset)
  • inventory (current assets)
  • accounts payable (current liability)

Therefore, in this context, we calculate available working capital using the following formula:

Working Capital Equation

Working capital is equal to accounts receivable, plus current inventory, minus accounts payable.

These values can be readily found on a company's balance sheet. The current portion of debt (payable within 12 months) is critical, because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

As an example, imagine a company has accounts receivable of $10,000, current inventory that has a value of $5,000, and accounts payable of $7,000. We can find working capital by:

Working Capital = $10,000 + $5,000 - $7,000 = $8,000

An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities, for example, has paid off some short-term creditors.

Implications on M&A

The common commercial definition of working capital for the purpose of a working capital adjustment in a mergers and acquisitions transaction (i.e., for a working capital adjustment mechanism in a sale and purchase agreement) is equal to:

Current Assets - Current liabilities (excluding deferred tax assets/liabilities, excess cash, surplus assets, and/or deposit balances).

Cash balance items often attract a one-for-one purchase-price adjustment.

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