Working Capital

​​What is Working Capital?

Working capital (WC) is a measure of a company’s financial health and liquidity. It is calculated as the difference between a company’s total current assets and total current liabilities. A positive working capital indicates that a company is able to pay off its short-term obligations and is generally a sign of good financial health.

Why is Working Capital important?

Working capital is important for software companies because it is a key indicator of the company’s ability to manage its operations and pay off its short-term debts. It is also important for investors, as it can be used to assess the company’s financial stability and predict future performance.

How is Working Capital Calculated?

Working capital can be calculated as follows:

Working Capital = Total Current Assets - Total Current Liabilities

Where:

Total Current Assets = Cash + Accounts Receivable + Inventory 

Total Current Liabilities = Accounts Payable + Short-term Debt

For example, if a software company has $1 million in cash, $500,000 in accounts receivable, $200,000 in inventory, $700,000 in accounts payable, and $500,000 in short-term debt, its working capital would be:

Working Capital = $1 million + $500,000 + $200,000 - ($700,000 + $500,000)

Working Capital = $1 million

How to Improve Working Capital?

There are several ways to improve working capital for software companies, such as:

• Increasing cash flow: Companies can improve their cash flow by increasing their sales or improving their collection policies.

• Reducing inventory: Companies can reduce their inventory levels by improving their inventory management process and reducing their inventory turnover.

• Reducing accounts payable: Companies can reduce their accounts payable by negotiating better terms with suppliers or taking advantage of early payment discounts.

• Reducing short-term debt: Companies can reduce their short-term debt by refinancing existing debt or taking advantage of debt repayment terms.

Why Investors Value Low Working Capital?

Investors often value low working capital because it is an indication of a company’s ability to manage its short-term obligations and pay its debts. Additionally, companies with low working capital tend to have higher returns on invested capital, which can lead to higher returns for investors.

How Working Capital Relates with Other Financial Metrics?

Working capital is closely related to other financial metrics, such as return on assets (ROA), return on equity (ROE), and current ratio. ROA and ROE measure a company’s ability to generate profits from its assets and equity, respectively. The current ratio measures a company’s ability to pay off its short-term liabilities.

By improving its working capital, a software company can improve its ROA, ROE, and current ratio, which can lead to higher returns for investors.

Sources

• Investopedia. (2020). Working Capital. Retrieved from https://www.investopedia.com/terms/w/workingcapital.asp 

• Inc. (2019). What is Working Capital and How to Improve it? Retrieved from https://www.inc.com/encyclopedia/working-capital.html 

• Investopedia. (2020). Return on Assets (ROA). Retrieved from https://www.investopedia.com/terms/r/returnonassets.asp 

• Investopedia. (2020). Return on Equity (ROE). Retrieved from https://www.investopedia.com/terms/r/returnonequity.asp 

• Investopedia. (2020). Current Ratio. Retrieved from https://www.investopedia.com/terms/c/currentratio.asp