Companies often find themselves ready to expand on their current business or to venture into a new business. Both of these actions require additional financing. Companies may choose to issue additional stock, although this dilutes the current ownership. Or companies may choose to borrow funds, although this requires the company to repay the funds with interest. For many companies, working capital provides a viable option for financing the business.
Working Capital Definition
Working capital consists of the excess of the company’s current assets over the company’s current liabilities. Current assets represent everything the company owns that it expects to convert into cash or use the benefit of within one year, such as accounts receivable, inventory and prepaid insurance. Current liabilities represent everything the company owes that it expects to pay within one year, such as accounts payable, wages payable or subscriptions payable.
When a company uses working capital to finance its business operations, it converts the current assets into cash or exchanges ownership of the current assets for cash. The business might sell inventory or accounts receivable accounts, for example. The company then uses the cash received to finance the company’s activities. This allows the business owners to retain their current level of ownership. Other forms of financing, such as issuing stock or acquiring partners, increases the number of owners and reduces the ownership percentage of the current owners.
After converting working capital into cash, the company is free to use the funds. The company incurs no additional financial burden through this method of financing. It simply uses the cash it currently has. By using working capital to finance the business activities, the company pays no interest on the funds. Other financing options, such as borrowing from the bank or issuing bonds, require the company to make regular interest payments.
A company who uses its own working capital to finance the business operations maintains the pride of being self reliant. For many entrepreneurs, the desire to build the business on their own merit ranks higher than advancing the business at other costs. This company strives to increase its working capital to a sufficient level prior to expanding its business.