Definition of working capital and its importance

Company needs current assets to run the daily business operation. So, Working Capital is the liquid capital (money) accessible within the company to take with its day-to-day activities. In other word, by calculating working capital we can find out the value of our current assets and we are able to meet our financial obligations. It is simply the current assets in excess of current liabilities is also known as working capital. Current assets include cash, bank, debtors, bill receivables, prepaid expenses, outstanding incomes. Similarly current liabilities includes creditors, outstanding bills, bank overdraft, bills payable and short term loans, outstanding expenses, advance incomes .We can calculate the working capital by following the formula is:

Working Capital =Current Assets – Current Liabilities

Importance of working capital

Working capital is an indicator of a company’s operating liquidity. If company has enough working capital they should be able to pay all of their short term expenses and liabilities and create their reputation in market. But if a company has zero working capital and then company cannot pay creditors in emergency time and either company becomes bankrupt or takes loan at higher rate of Interest.

The importance of working capital is to gives shareholders an idea of the company’s core or original operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations.

Working Capital is important for large companies' ability to borrow, increase their share price, and pay expenses and short-term debts. Large companies pay attention to WC for the same reason as small ones do. Working Capital is a measure of liquidity, and thus is a measure of their future credit-worthiness.

Working Capital is important for small companies that cannot access financial markets to borrow, and for start-ups that need to survive until they break even. WC cannot guarantee whether a company is financially sound, but it gives some insight.

Working Capital is important to because it is a measure of a company's ability to pay off short-term expenses or debts. On the other hand, too much working capital means that some assets are not being invested for the long-term, so they are not being put to good use in helping the company grow as much as possible.

Working Capital is only one measure of a company's operating liquidity. It is not the only measure, and it is certainly not a guarantee of a company's ability to pay. A company may have positive Working Capital, but not enough cash to pay an expense tomorrow. Similarly, a company may have negative Working Capital, but may be able to adjust some of their debt into long-term debt in order to reduce their current liabilities.

Working Capital is an important metric, but is not the whole story of a company's financial health. Short term funding is important because, with long term funding already in place, the business still needs short term funding to operate. Without the short term funding, the business will go bankrupt.

Difference between NOPAT and Net income

Net Income

Net income appears on the company’s statement of income. It is the difference between total sales revenue and total costs and expenses. Total cost includes cost of goods sold including depreciation, and total expenses include selling, general, and administrative expenses, plus income deductions. Net income is usually specified as to whether it is before income taxes or after income taxes and interest expenses. It is important to differentiate between revenues and income, as revenues are the earnings of the company before subtracting expenses.

 Net Profit after Taxes

Net profit after taxes is the net income of the organization less all taxes. It is the sum of all revenues less all expenses, including cost of goods sold and all taxes. While it is almost the same as net income, this terminology frequently appears on the company’s financial statements in order to differentiate between profits before and after subtracting taxes. The only one difference is it does not include interest expenses.

Net income is a measure of the profitability of a venture after accounting for all costs. It is a quick indicator of the financial health of a company, which appears on the company’s statement of income. Net income is what remains after subtracting all the costs and NOPAT (Net Operating Profit after Taxes) is a measure of profit that excludes the costs and tax benefits of debt financing. NOPAT is what a company would earn if it didn’t have any debt. It is a company’s operating profit after subtracting     its tax liability. It can be expressed as: 

       NOPAT = EBIT (1-tax rate)

For companies with no debt and thus no interest expense, NOPAT is equal to net profit. This means NOPAT represents the company’s operating profit that would accrue to shareholders (after taxes) if the company had no debt. Because operating profit does not deduct interest expenses, NOPAT shows what a company’s net profit would have been if it were debt free. As such, it may provide a more accurate description of a company’s efficiency of operations for highly leveraged companies. Therefore, NOPAT is a better measure of performance of the firm than net income.

So, NOPAT is good to calculate or measure of the performance of a firms operation because debt lowers income. NOPAT is the amount of net income a company would generate if it had no debt and financial assets. To know the original indication of a company’s operation performance, NOPAT would want to take out debt to get a clearer image of the situation.

   

References:

• Aldridge, C. (nd). What Is the Difference Between Net Income and Net Profit After Tax. Retrieved from:http://smallbusiness.chron.com/difference-between-net-income-net-profit-after-tax-20663.html
• Brigham, E.F. & Ehrhardt, M.C. (2011).Financial Management: Theory and Practice.Mason, Ohio: South-Western Cengage Learning.