Why is a company’s liquidity so important?
Patrick2023-12-29T16:15:58+00:00Concept and Meaning of Working Capital in a Company.
The concept of working capital in a company encompasses several ratios and formulas that are fundamental to understanding the evolution of businesses, their viability and their financial health. Among these indicators, working capital stands out.
You have probably heard expressions such as “that company has liquidity problems” or “that company closed due to a lack of liquidity”. But do you really know what this term implies and do you understand its meaning?
In the following text, we will explore in detail what liquidity represents in a company, what it entails to have excess or shortage of liquidity and, most importantly, how this key financial parameter is calculated.
What is working capital?
Understanding the difference between liquidity and solvency is fundamental to understanding a company’s working capital. These terms are often confused, but they have nuances that clearly differentiate them.
Solvency refers to the ability to meet long-term financial liabilities, while liquidity represents the ability to convert assets into cash quickly without significant loss of value. Both aspects address a company’s financial commitments and resources.
Working capital, also known as current assets, comprises all assets and rights that a company can convert into cash in less than one year. These assets are usually associated with the short term and are used in the production process. For example, in a publishing house, the paper and ink needed to print books would be an essential part of current assets.
Working capital is the difference between current assets and current liabilities, representing the resources available to finance day-to-day operations and meet short-term obligations. In short, working capital provides a key financial indicator for assessing a company’s liquidity.”
How is working capital calculated?
Before calculating working capital you need to know the composition of the company’s balance sheet, which is divided into assets and liabilities (both should add up to the same amount).
– Assets comprise goods and rights, such as fixed assets, financial investments, inventories or cash. It is subdivided into non-current (long-term) assets and current (short-term) assets.
– Liabilities include all obligations, such as creditors or debts. It is divided into equity (capital and reserves), non-current liabilities (long-term debts) and current liabilities (short-term debts).
The calculation is straightforward: Working Capital = Current Assets – Current Liabilities.
It is clear that working capital represents the short-term resources that the company uses to finance its daily operations and maintain its functionality. This indicator is essential to ensure the continuity of the company in the short term.
Characteristics of working capital
Current assets represent a vital part of a company’s financial structure. It acts as the short-term financial engine, providing the flexibility and solidity necessary to meet commitments and ensure the smooth daily flow of operations. It has the following particularities:
– It serves to pay off short-term debts.
– Its capacity to be converted into cash is less than twelve months.
– It finances the daily expenses of the company.
– It is also used to cover outstanding debts from customers.
– It includes raw materials in inventory or products ready to be sold.
– Cash held in cash on hand and in banks is part of this asset”.
Why is this financial indicator so important?
The importance of this financial indicator lies in its ability to reveal the real situation of the business and enable crucial decisions to be made to ensure business viability.
The concept of working capital is fundamental to assessing the soundness of the business, providing a short-term perspective of available cash. Skillfully handling this information is crucial to effectively manage liquidity.
In addition, working capital is often linked to working capital, an element that encompasses long-term financial resources and sustains business activity in the short term.
This metric provides a clear picture of the short-term financial health of the company.
Calculating working capital involves subtracting current liabilities from current assets or working capital. The result can be positive or negative, indicating two different situations:
- Positive working capital occurs when current assets exceed current liabilities, indicating an ability to pay off short-term debts and a sound financial position.
- Negative working capital occurs when current liabilities exceed current assets, revealing a lack of liquidity. This is evidence of difficulties in paying upcoming debts.
In case of a liquidity shortage, it is crucial to analyse cash liquidity ratios considering the particularities of your sector and recent actions. If you are able to meet your immediate commitments, but the answer is negative, it is crucial to perform a diagnostic to identify and solve the reasons behind this situation.
Excess liquidity can also be detrimental. Having more resources than short-term commitments may indicate poor financial management. The solution could involve strategic investments or the distribution of dividends to shareholders.
In summary, effectively managing liquidity and working capital involves making accurate and strategic decisions to maintain the financial stability of the company.