All About Working Capital


What is working capital?

Working capital, an efficient tool to measure an organisation’s financial health, is the difference between an organisation’s current assets and current liabilities. Working capital, also termed Net Working Capital (NWC), indicates the amount of money a business has to meet its present and short-term obligations. Thus, working capital helps gauge a company’s operational and financial efficiency.

KEY TAKEAWAYS

  • Working capital is the difference between an organisation’s current assets and current liabilities
  • It can either be positive or negative
  • Working capital helps measure a company’s short-term financial health and operational efficiency
  • Net working capital is measured by subtracting current liabilities from current assets

Importance of WC

While working capital indicates an organisation’s financial strength, here are more reasons why the metric is essential:

  • Planned management of a company’s working capital helps avoid cash crunches during unforeseen circumstances.
  • Proper management of working capital leads to more business profits and investments, thus maximising returns.
  • With efficient working capital management, a company can fulfil its payment obligations and maintain its goodwill.
  • A company with sufficient working capital can pay its employees on time, increasing employee motivation and fostering a good working environment.

How to calculate WC

Working capital is measured with the help of the following formula:

Current assets- Current liabilities= Net Working Capital

Suppose a company has current assets of ₹1 Crore and current liabilities of ₹50 Lakh. This indicates the company has ₹50 Lakh to meet its short-term financial needs.

Note: During the calculation of working capital, only short-term assets and liabilities are considered. The current assets may include cash in the business account and account receivable (the amount your customers owe you, inventory expected to be converted into cash within one year, etc.). Short-term liabilities may include the money you owe to vendors/creditors, other debts and outlays, salaries, taxes, etc.

Key applications of WC

Working capital has the following applications:

  • Maintaining an optimum inventory level
  • Timely payments to creditors
  • Managing the company’s day-to-day expenses and short-term debts
  • Meeting unforeseen business expenses
  • Marketing
  • Expansion of business

Sources of WC

The sources of working capital are as follows:

  • Spontaneous sources: The spontaneous capital sources are formed during regular business activities and are readily available with less effort and costs than other financing methods. These include trade credits such as bills payable, notes payable, and sundry creditors.
  • Short-term sources: The capital sources available to a company for less than one year are known as short-term sources. These may include internal sources, such as tax and dividend provisions and external sources, such as loans from banks, trade credit, public deposits, bank overdraft, bill discounting, etc.
  • Long-term sources: Long-term sources of capital are the ones available to businesses for a longer duration, usually more than a year. Long-term sources may include internal sources, such as retained profits and provisions for depreciation and external sources, such as long-term loans, debentures, and share capital.

Positive vs Negative WC

A positive working capital indicates that the company has more current assets than its current liabilities. It means the company has sufficient resources to fulfil its short-term obligations.

Negative working capital, on the other hand, indicates a lack of enough funds to pay for current liabilities. It is a sign of poor financial health and low liquidity, due to which the company may have problems clearing off its debts.

WC and Current Ratio

The working capital ratio is also known as the current ratio. It is a measure of a firm’s ability to pay off the current liabilities with the current assets. It can be determined by using the following formula:

Current assets/ Current liabilities = Working Capital Ratio.

Let’s suppose the current assets of a company are valued at ₹1 Crore and its current liabilities are valued at ₹50 Lakh. Thus, the working capital ratio would be 2:1, which indicates the company has enough funds to manage its day-to-day expenses.

Types of WC

Following are the types of working capital:

1. Gross working capital: Gross working capital is the amount invested in assets that can be readily converted into cash. In other words, highly liquid assets come under this category, such as stocks.

2. Net working capital3: It represents the difference between current assets and current liabilities of a company. It helps gauge a company’s ability to pay its short-term debts. There can be either a positive or negative net working capital.

3. Permanent working capital: It refers to the minimum amount of liquid assets required to meet current liabilities. It is also known as fixed working capital and depends on the business’s size.

4. Temporary working capital: Also referred to as cyclical or variable working capital, temporary working capital is the difference between permanent and net working capital.

5. Regular working capital: It refers to the minimum amount of capital needed to cover regular business expenses. It may include salaries, wages, or material costs.

6. Reserve margin working capital: This is the capital kept aside as a safety cushion during unforeseen situations, such as strikes, natural calamities, etc.

7. Seasonal working capital: As the name implies, this working capital is meant for business operations during peak seasons.

8. Special working capital: This working capital is meant for special needs, such as advertising campaigns, new product development, etc.

Final words

Now you know about working capital, its importance, and its types. By ensuring timely payments of financial obligations, working capital helps maintain a business’s goodwill. Thus, understanding its crucial role and maintaining an optimum level of working capital is essential to running a business.

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