Net working capital includes short-term assets and liabilities. It is calculated by subtracting current liabilities from current assets and indicates a company’s ability to meet its short-term financial obligations. A positive net working capital shows the good financial health of a company, and thus, lenders feel more confident in the business's growth potential.
This blog helps you understand the meaning of net working capital and its importance while acquiring a Business Loan. Read on!
What is the Net Working Capital?
Net working capital is a crucial factor while analysing business profits. It reflects how smooth the business cash flow is. The ideal position is one where your business holds more assets than debts and liabilities.
Net Working Capital Formula = Current Assets – Current Liabilities
For example: ₹84 Lakh (current assets) – ₹45 Lakh (current liabilities) = ₹39 Lakh (net working capital).
What are Current Assets?
Items on the balance sheet that can be converted into cash within a year are known as current assets. There are three main types of current assets as follows:
Cash and Cash Equivalents
This includes the business’s cash holdings and highly liquid investments that can be quickly converted into cash. For example, short-term deposits, treasury bills, and money market instruments are generally considered cash equivalents.
Inventory
This includes all the goods a business owns that have not been sold yet. It also includes any raw materials and partially assembled goods.
Accounts Receivable
This includes all the money that is expected to be received by the business from its customers or other sources. Suppose your business has cash worth ₹24 Lakh and inventory worth ₹60 Lakh. This means that you have current assets worth ₹84 Lakh.
What are Current Liabilities?
Current liabilities are those items on your balance sheet that must be paid within one year. They are also called short-term financial obligations of a business.
Salaries Payable
Usually, this is the biggest current liability of a small to medium-sized business. The wages that need to be paid to employees within one year are included as current liabilities.
Accounts Payable
This refers to any funds that need to be paid to vendors, utility services, rent, taxes, etc. The interest rate on any outstanding dues also adds to the total current liabilities amount.
Debts Payable
This includes any debt obligations or repayments that are due within one year. If you need to pay ₹30 Lakh every year to your employees and you have an annual debt of ₹15 Lakh, then your current liability is ₹45 Lakh.
Tracking current liabilities closely helps your business avoid cash flow shortfalls and maintain a healthy net working capital position.
Positive vs Negative Working Capital
Positive working capital indicates that a business has sufficient liquidity to meet its short-term financial obligations. Negative working capital can be a cause for concern, as the business may struggle to meet its immediate liabilities. A positive net working capital position signals financial stability to lenders and can improve your eligibility for a working capital loan.
Why is Working Capital Important?
Working capital goes towards funding day-to-day operations and meeting short-term objectives. When a business has sufficient working capital, it can comfortably pay off all its overhead expenses. This includes salaries of employees, bills due to various suppliers, and even tax and interest payments.
Positive working capital indicates a company’s financial stability and ability to manage its short-term obligations effectively. As a result, lenders may be more willing to approve the required loan amount and may offer more favourable terms and conditions.
Advantages of Working Capital
Here are the three major advantages of having adequate working capital:
Better Liquidity Management
Sufficient cash flow ensures that all daily operations of a business are running smoothly. This impacts a business's overall performance and reflects its positive brand image.
Higher Chances of Earning Short-Term Profits
A business with surplus working capital may invest excess funds in short-term opportunities. If these investments are managed effectively, they can generate additional income and improve overall profitability.
Aids in Decision Making
The stakeholders and top-level managers can make financial decisions more confidently after having a clear idea of daily fund requirements. It also helps them switch the source of funds to maintain a sufficient level of working capital.
How to Increase Net Working Capital?
If you are looking to increase your net working capital, you can follow the tips mentioned below:
Unlock Cash from Long-Term Assets
Long-term assets do not count as current assets. This is because the value of these assets is spread over a period of over a year. Converting them to cash improves access to liquid funds and strengthens net working capital.
Refinance Your Debt
A business may have a larger amount of short-term debt, such as credit card payments and lines of credit. It is possible to refinance such debt and turn it into longer-term debt. A working capital loan is a practical option to repay short-term debt and reduce current liabilities.
Sell Excess Inventory
A business may sometimes find itself with excess inventory. Reviewing inventory levels can help identify items that can be sold quickly to generate cash. While inventory is classified as a current asset, it is generally less liquid than cash and cash equivalents.
These steps help your business maintain positive net working capital and reduce dependence on emergency funding.
Understanding Working Capital Loan
A working capital loan is designed to finance short-term operational expenses and help bridge the gap between a business’s current assets and current liabilities. According to the SIDBI MSME Pulse Report, these loans are an important source of funding for small businesses across India.
Here are the key benefits of a working capital loan and what to look for:
- Loan amount: You can get a loan up to ₹1 Crore, subject to your business profile and eligibility.
- No collateral: Many working capital loans do not require collateral, making it easier for a wider range of small businesses to access funding.
- Flexible repayment: Working capital loans offer flexible terms of repayment that can be aligned with your business cash flow cycle.
- Interest rate: Interest rates vary depending on factors such as your credit profile, business performance, loan amount, and repayment tenure.
- Quick disbursal: Working capital loans are processed faster when compared to term loans, with only basic documentation required for your business to apply for the loan.
Before applying for a loan, you can use a working capital loan EMI calculator to estimate your monthly payments. It is based on the loan amount, interest rate, and tenure, helping you plan your business finances more effectively.
Read Also: How Working Capital Loan Can Help Grow Your Small Business
To Conclude
Net working capital is the difference between current assets and current liabilities. It is one of the most important indicators of a business's financial health. Positive net working capital enables a business to operate smoothly and may improve its ability to secure additional financing on favourable terms. Consider Poonawalla Fincorp for a working capital Business Loan with competitive interest rates and flexible repayment options.
FAQs
What does net working capital mean?
Net working capital is the amount calculated as the difference between the current assets and current liabilities of a business.
Why is calculating net working capital important?
Calculating net working capital is important to ensure that your business has sufficient funds to operate smoothly and meet its short-term financial obligations.
What types of business loans are available for working capital needs?
The types of working capital loans available to businesses include unsecured business loans, cash credit facilities, invoice finance, and short-term loans for use by businesses.
Can I get a working capital loan without collateral?
Yes, most lenders providing working capital loans do not require any form of asset to use it as a collateral.
What is a good net working capital ratio?
A good net working capital ratio indicates that a business has sufficient current assets to meet its short-term obligations. However, the ideal ratio may vary across industries.
We take utmost care to provide information based on internal data and reliable sources. However, this article and associated web pages provide generic information for reference purposes only. Readers must make an informed decision by reviewing the products offered and the terms and conditions. Loan disbursal is at the sole discretion of Poonawalla Fincorp.
*Terms and Conditions apply