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Working Capital-What is the working Capital formula? It is an area that is involved with a great deal of money flow. Put simply a crucial, often overlooked, part of any business.
It is an area that is not understood properly leading to working capital management problems. If it fails to work well the business will suffer.
A simple working capital definition is the current assets of the business less the current liabilities. In these areas there are so many parts of a business at work.
It is necessary to gain an understanding of these different accounting parts to fully understand and learn how well money flows.
This tutorial starts to discuss these key areas that are at play within working capital.It introduces two areas you may already know or have heard about called trade accounts receivable and trade accounts payable.
Activity ratios help us focus on working capital, and follow on from the financial ratio tutorials that previously discussed liquidity in the business.
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If you prefer to read rather than watch the video here is a summary transcript:
"In this tutorial the key learning points will be: first of all, an introduction to this important concept of the working capital formula; we’ll look at some common misconceptions around this topic; and this will lead us into what really is working capital in any business, and in doing that we’ll tease out some of the key important issues for a thorough understanding of this subject.
So, this area of working capital really is the engine of the business and if you want to use that analogy in talking about a car engine, if the car engine doesn't go well or goes completely, you know what happens - the car is in need of help, it’s in need of repairs, it needs looking at.
In a business, because an awful lot of money circulates in this area called working capital, in essence if too much money is tied up in this area it’s a complete waste of resources. But balanced against that, if the business has too little, that too can cause problems. So it’s about striking an appropriate balance.
Before we analyse activity ratios and the working capital formula a little bit further, why is this area often misunderstood? Quite simply because many people are not exactly sure what it means. People hear the name, they think it’s an unusual name, but what does it really mean?
Generally, most people know what capital means, but when we put this word called working in front of the word capital it suddenly almost changes the understanding of it.
But the key is the name working. Why is that? Because this type of capital on a minute by minute, hour by hour, day by day, week by week, year by year, is continually doing the hard work in any business.
So it’s time to start to see what does it really include?
Quite simply, the working capital definition is the current assets of the business less its current liabilities and the majority of the working capital in any business, that is the majority of the current assets less the current liabilities, will fall into three key business areas.
Firstly, the accounts receivable, and these are people who owe the business money. The second key area will be the accounts payable and these are people that the business owes money to. Thirdly, the final key area is inventory turnover and this is commonly referred to as the stock in the business or the stock turnover.
So know that you know the working capital definition and you know three major areas that it relates to, there are three points to notice.
Firstly, two of the three key areas in any business relate to the current assets and these are your accounts receivables and your inventory turnover.
Secondly, one of these areas also relates to current liabilities in the business and these are your accounts payable.
Thirdly, the calculations that you see are based on what are called trade accounts, and these are the heart of any business. For example, your trade accounts receivables - these are the customers who owe the business money.