Describe the concept of working capital

Answer 1

UNDERLYING CONCEPTS AND TERMINOLOGY

There is a distinction between current assets and liabilities and noncurrent assets and liabilities. The current–noncurrent distinction refers to whether a firm will convert an asset to cash, or consume it, or sell it within one operating cycle and whether a firm will pay or otherwise settle a liability within one operating cycle. Because the operating cycle for most firms is one year or less, one year is the conventional cutoff for distinguishing a current and a noncurrent asset or liability.

Working capital is the difference between a firm's current assets and its current liabilities. The current ratio, also called the working capital ratio, is current assets divided by current liabilities. Both working capital and the current ratio provide information about liquidity—a firm's ability to meet short-term obligations as they come due. A firm with assets that will convert to cash within the next 12 months, in excess of its obligations to pay cash in this same interval, has positive working capital and a current ratio that exceeds one. When current liabilities exceed current assets, working capital is negative and the current ratio is less than one. Although most firms have positive working capital, negative working capital does not mean a firm cannot meet its near-term obligations. A firm may, for example, have a bank line of credit that allows it to borrow cash to meet short-term obligations.

The accountant's definition of working capital (total current assets minus total current liabilities) differs from the definition often used in finance. The difference pertains to the treatment of items that do not clearly relate to the firm's operations; working capital as defined in finance equals current operating assets minus current operating liabilities, excluding current assets and current liabilities that reflect the financing structure of the firm, called financial assets and financial liabilities. The general rule to distinguish an operating asset (operating liability) from a financing asset (financial liability) is its purpose: does the firm use the item directly in operations, or use it to finance those operations? On the asset side, current financial assets typically include assets that generate some form of interest or investment income, such as marketable securities and other short-term investments. On the liability side, current financial liabilities typically include obligations that accrue explicit (or implicit) interest, such as short-term bank borrowings and the current portion of long-term debt. To clarify, the term working capital is used as the accountant uses it, including both operating and financial current assets and current liabilities.