The term working capital refers to a firm's investment in current assets. Net working capital refers to the excess of current assets over current liabilities and can be thought of as the circulating capital of a business. Effective control of this circulating capital is one of the most important functions of financial management.
There are a number of reasons for the importance of working capital management. One major reason stems from the relative urgency of working capital decisions. There is a very close relationship between sales growth and growth of current assets. Current assets tend to grow spontaneously with increases in sales, and the growth of these assets must be controlled effectively if a financial manager is to maintain control of the firms asset structure. As current assets grow, they must also be financed. Part of this financing will come from current liabilities, part from other external sources of capital, and part from reinvested earnings. Control of the portion of current asset financing that comes from current liabilities is an important aspect of working capital management.
A second major reason for the importance of working capital management is the size of the working capital accounts. Current assets, particularly accounts receivable and inventory, often represent the largest single category of asset investment for many firms. This is particularly true for small and rapidly growing businesses.
Looking to the right-hand side of the balance sheet, current liabilities often provide a major source of financing for a firm. For small