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Working capital, also known as net working capital (NWC), is the difference between a company's current assets (such as cash, accounts receivable, and inventory) and its current liabilities (such as accounts payable and debts). It is a measure of a company's liquidity and short-term financial health, indicating the amount of cash and other liquid assets available to cover short-term debts.
Working capital is calculated by subtracting current liabilities from current assets. The components of working capital vary depending on the industry and specific business needs. Proper management of these components is important for maintaining a healthy financial position and ensuring the company's ability to pay bills and invest in growth.
Effective working capital management is important for several reasons. First, it ensures a company's ability to meet short-term obligations, such as paying bills and wages. This helps maintain a positive reputation with suppliers and employees, which is key for business success. Second, it allows businesses to invest in growth opportunities, such as expanding operations or launching new products. This can lead to increased revenue and profitability in the long run.
To optimize working capital, businesses can focus on several strategies.
Working capital ratio analysis involves evaluating a company's liquidity and short-term financial health by calculating the working capital ratio. This ratio is obtained by dividing current assets by current liabilities. A higher ratio typically indicates a healthier financial position and better capacity to repay short-term liabilities with short-term assets.
A high working capital ratio suggests a strong financial position and the ability to pay current liabilities, while a low ratio indicates potential challenges in meeting payment obligations.
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