What Working Capital Is and Why It Is Important for A Business

What is working capital? 

According to the principles of accounting (https://www.principlesofaccounting.com/chapter-4/), is represented as " Current assets - Current liabilities ". Notice that the "current" reflects you can transfer it into cash in a short period, and also means the obligations you have to repay in a short period. So the remain after current assets minus current liabilities means how much quick assets or highly liquid assets you have on your hand to run the business in a particular period. 

Why it is important for a business?

The working capital reflects your abilities to fuel business activities and operating. Suppose you have $1,000 in cash, $5,000,000 worth of real estate, and receive a regular paycheck of $3,000 every month on 28th. Here is the situation, you have an obligation to pay $5,000 on February 25, you only have $1,000 cash on hand, the real estate might take 2-3 years to sell, your paycheck must wait until February 28. What would you do? It's similar to the situations while we are running a business. 

As an example, describe a business that operates where you live and describe how knowing what the working capital of that company would be useful to the business leaders of that company and to outside investors.

My father owns a food company in Taiwan where I live. To run the business, he has to track the pork inventory and purchasing when it's less than the minimization. The pork needs to be stored in a large fridge and costing electricity, and the payroll is also the cost of operating. The working capital is needed to pay the electricity bill, the pork inventory, and the payroll, in order to keep the business running and growing. The electricity bill, the pork inventory, and the payroll are near-term obligations, the current liabilities, all be billed every short period and must be paid in time. On the other hand, the receivables and cash are the two accounts which most likely be used to pay those near-term obligations. Obviously, if he does not have enough cash or other current assets on hand to pay those bills, his financial stress will increase. 

The food company is being organized as a sole proprietorship and run by my father, so it may not has any outside investors. But if we imagine that it is a corporation and has issued common stocks, the working capital could be a cause to lower its value on shares. New investors will analyze the working capital to evaluate the company's ability to deal with financial stresses since it's important to their investment.

References

Walther, L. M. (2012). Principles of accounting. Logan, UT: Utah State University. Retrieved from https://www.principlesofaccounting.com/chapter-4/

Discuss The Difference Between "Nominal" and "Real" Accounts

Now we begin to look at the "accounting cycle", culminates in closing the books and producing financial statements. While expanding the picture to take in the full accounting cycle and culminates in closing the books and producing financial statements, balances of some accounts are carried forward from period to period, some were not. To understand why, we need to know the differences between these two types of accounts, which are "nominal" and "real" accounts. 

The Nominal Accounts

The nominal accounts are revenue, expense, and dividend accounts, these accounts must be reset to begin the next accounting period. 

The Real Accounts

The real accounts are assets, liabilities, and equity accounts, these accounts must be carried forward from period to period. 

What Are The Differences?

1.Reset or not

The balance of the real accounts, assets, liabilities, and equity accounts, be carried forward from period to period. In contrast, the nominal accounts are revenue, expense, and dividend accounts, these accounts must be reset to begin the next accounting period. For instance, It's just like your bank accounts, the balance of the account(Real account) is carried forward while you deposit or withdraw. The nominal accounts, on the other hand, reflect the amounts of your deposit and withdraw.

2.The Results or Happening

The amounts of revenues, expenses, and dividend accounts during a particular period, depending on how much you earned or paid. In short, it's the happening events of the period. In contrast, the amounts of assets, liabilities, and equity depend on the results of the prior, it's the achievements that you have already done before measuring the revenues, expenses, and dividends. Recall the example of your bank account, your balance reflects the result of your deposits and withdraw. Your deposits and withdraw are printed on the record of transactions, they are events and activities of your account, reflect the happening nominal events.

Why are they so-called?

The reason why they are so-called "nominal" and "real" accounts, is actually achieved or not. As we know that the net income equals revenues minus expenses, so we have the actual increase or decrease on the balance sheet after the result of the net income. If you have $1,000,000 in revenue, but you also have $1,000,000 in expense, you will end up with zero increase in the assets. Moreover, if the expense is $2,000,000 , you will end up with $1,000,000 in liabilities. The result will finally accumulate to the real accounts, the balance sheet, assets, liabilities, and equity.

What type of information is contained in nominal accounts?

Since the nominal accounts are the revenues, expenses, and dividend accounts, so they contain the information to record revenues, expenses, and dividend accounts. The information contained in nominal accounts is usually income statement accounts such as revenue data, expense data, and gain or lose data.

What types in real accounts? 

The real accounts are also known as capital accounts, which contain balance sheet accounts, asset data, liability data, and equity data. 

Which financial statement contains the information from nominal accounts?

Obviously, the income statement contains the information from nominal accounts, since it has the amounts of revenues and expenses.

Which contains the information from real accounts?

Clearly, the balance sheet involved assets, liabilities, and equity, which contains the information for real accounts.

References

Walther, L. M. (2012). Principles of accounting. Logan, UT: Utah State University. Retrieved from https://www.principlesofaccounting.com/chapter-4/