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What is Working Capital? Its Meaning, Example and Importance
For a business to operate, it needs money. This money is often called the lifeblood of the business because it's essential to keep the business running. It's like the cash or deposits a business keeps on hand to pay for day-to-day operations. Working capital is a vital measure of a business's ability to pay its short-term debts. It's an important metric that shows how financially healthy a business is.
Working capital is the difference between the current assets of the business and its short-term debts & current liabilities. You must have a positive working capital as it demonstrates that the business’s financial goals are achieved, and your business is financially stable to invest in other business operations. The importance of working capital is high especially for small businesses as they rely heavily on short-term financing. This also increases the significance of working capital for such businesses.
The working capital formula is:
Working capital = Current Assets – Current Liabilities
This formula tells us about the short-term liquid assets available after short-term liabilities have been paid off. The Working Capital formula is a measure of a company’s short-term liquidity and is an important factor for performing financial analysis, and managing cash flow.
For example, a company has current assets worth Rs.5,00,000 and current liabilities worth Rs.2,00,000. So, the working capital of the company will be Rs.3,00,000. Using the above-mentioned working capital formula:
Rs.5,00,000 – Rs.2,00,000 = Rs.3,00,000
The working capital calculation is used for understanding the liquidity of the business. Similarly, you can find out the working capital ratio using the working capital ratio formula:
Working capital ratio = Current Asset/ Current Liabilities
Using the above given example, where the current asset is Rs.5,00,000 and current liabilities are Rs.2,00,000. Your working capital ratio is 2.5
Rs.5,00,000/Rs.2,00,000 = 2.5
Working capital management is a business tool that ensures the best usage of a business’s current liabilities and assets for its effective operation. The sole aim of working capital management is to examine a business’s current assets and liabilities to maintain cash flow and meet the business’s financial obligations. It assists in addressing planned as well as unplanned expenditures and determining the business’s efficiency by maintaining liquidity.
Working capital management is a business tool that helps businesses to make use of their current assets & liabilities and maintain an adequate cash flow to meet various business’s financial obligations. By managing working capital effectively, businesses can free up cash that would otherwise be lost on the balance sheet. To put it into simple words what is working capital management all about? Working capital management helps to improve the business’s profitability and earnings.
Also Read: Why Managing Working Capital is Important for Future Funding?
Now that you know what is working capital all about and which capital is known as working capital, let’s understand the importance of working capital finance management. No one can deny the importance of working capital in a business. Therefore, we must do the working capital finance management to understand and manage the working capital in a business. So that the business can flourish without any problem. Its importance is not restricted to just one aspect. Doing so helps you to:
The very first importance of working capital finance is planning for funds. With a holistic view of your working capital, you can plan for funds accordingly. When you know the likely expenses to be incurred at present or in the future, you can chalk out the need for funds accordingly. If you are likely to incur a shortfall, then you can apply for an unsecured business working capital loan to overcome a cash crunch.
The second importance of working capital finance is that it aids in decision-making. An accurate estimate of your working capital and its management helps you and your finance team to appropriately manage the available funds and decide how much to spend in the near term. The right estimate allows you to save and pay off your obligations with the utmost ease.
Another importance of working capital finance is that it improves creditworthiness. When you have adequately planned for your working capital, the same aids in timely payment to your vendor and lenders if any. This does not only strengthen relationships but also enhance your creditworthiness in the market. It helps you obtain a customizable business working capital loan to meet your fund requirements in the future.
Building credibility is another importance of working capital finance management. It’s through working capital that you pay your employees and vendors. Effective management of working capital helps you make timely payments to them, thus building your credibility. It also motivates your employees to go the extra mile for the organization and go beyond their call of duty.
Also Read :- How Working Capital Loan Can Help Grow Your Small Business
The importance of working capital finance in business planning is known to everyone and how working capital finance plays a crucial role in the business plan. While formulating a business plan, you must make adequate provisions to lay your working capital needs and identify its sources. While the sources could be cash credit, bill discounting, trade deposits, and notes payable, among others, the plan must also include the different types of working capital that are as follows:
Also known as fixed working capital, it includes the minimum current assets that are required to keep operations running.
This refers to the extra working capital that’s used for various operational expenses.
As the name suggests, this capital is kept as a reserve for unforeseen expenses coming your way. This working capital helps you to meet liquidity needs in an emergency.
It refers to the extra working capital that your business needs for fulfilling objectives such as launching new products, effectively managing risk, and undertaking marketing campaigns, among others.
Sometimes, your business may require additional working capital. For example, you may need additional working capital to pay vendors and suppliers during peak business season. In such a scenario, you can avail a Business Loan for working capital.
Such loans are also known as unsecured business Capital Working Loans as you don’t need to pledge any security to your lender. All you need to do is to fill up an application form and upload the relevant documents. Upon successful validation, the loan amount is disbursed and credited directly into your account.
The loan also comes in handy when you are undergoing a cash crunch due to non-payment from customers or experiencing a dip in business due to black swan events like the Covid-19 pandemic. The funds received help you to sail through tough times and meet your obligations. Poonawalla Fincorp offers a Working Capital Loan for business growth in a jiffy at a competitive rate of interest. Call us on our toll-free number 1800 266 3201 or write to us at customercare@poonawallafincorp.com to know more.
Low Working Capital indicates that the company is barely able to manage its day-to-day operations. Working capital is used for managing day-to-day operations and meeting short-term obligations. If a company has low working capital, it may face several challenges. Insufficient working capital can hamper the company's ability to meet its short-term obligations, such as paying suppliers and employees, resulting in liquidity issues. The company may struggle to finance its day-to-day operations, invest in growth opportunities, or handle unexpected expenses. It may also find it challenging to take advantage of favourable market conditions or negotiate favourable terms with suppliers. In extreme cases, a persistent lack of working capital can lead to financial distress and even bankruptcy if not addressed effectively.
Capital in business refers to the sum of all financial assets that are needed to produce business-related services and goods. These funds can be utilized to start business operations and meet daily expenses. Hence, the answer to your question- what is capital in business is simple. Working capital helps businesses to grow and expand.
The three sources of working capital are
a) Long-term – Term loans, retained earnings, share capital
b) Short-term – Deposits from the public, liquid cash on books
c) Immediate or Spontaneous – trade credit
The working capital ratio is calculated as
- Current Assets / Current Liabilities
The “ideal” value of the working capital ratio varies from industry to industry and also from one business cycle to another. In general, a ratio of 1:1 indicates that the business is in balance. A ratio of more than one indicates that the current assets are able to take care of the current liabilities on the books. However, it could also indicate that there are lots of unsold current assets.
Similarly, a ratio of less than one indicates that the business does not have sufficient current assets to take of current liabilities. However, it could also mean that the current assets are being sold-off at a brisk pace.
Hence, the ratio should not be taken in isolation, but should be considered in conjunction with other factors.
If a company sells its fixed asset, it releases cash to the books. This cash can be used to shore up the working capital. However, it is absolutely not advised to sell off a fixed asset to manage working capital. The management must ensure that the asset is being sold off without any adverse effects on its core operations. The converse is also true. The company should not finance a fixed asset purchase using working capital.
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Working Capital |
Cash Flow |
|
Working Capital is the level of current assets and liabilities within the organization |
Cash flow is the movement of cash into and out of the company |
|
Working capital generally refers to the ability of a company to pay off its immediate liabilities |
The cash flow statement indicates the amount of money that the business generates over a period |
|
The nature of working capital is “just-in-time” |
Cash flow presents a longer picture |
Net working capital refers to the difference between a company's current assets (such as cash, accounts receivable, and inventory) and its current liabilities (such as accounts payable and short-term debt). It represents the amount of funds available to finance day-to-day operations and indicates the company's short-term liquidity position. A positive net working capital suggests the company has enough assets to cover its short-term obligations, while a negative net working capital indicates a potential liquidity issue.
The difference between gross working capital and net working capital lies in the inclusion of current liabilities.
Gross working capital refers to the total current assets of a company, including cash, accounts receivable, inventory, and other short-term assets. It represents the company's investment in current assets to support its operations.
Net working capital, on the other hand, deducts the current liabilities from the current assets. It is calculated by subtracting current liabilities such as accounts payable, accrued expenses, and short-term debt from the current assets. Net working capital provides a more accurate picture of the company's liquidity position and its ability to meet short-term obligations.
The sole purpose of working capital is to ensure a company has enough funds to support its day-to-day operations, meet short-term obligations, and maintain smooth business activities.
Following are some steps to increase working capital:
a) Plan production well according to demand
b) Have an optimum pace of inventory turnover
c) Sell off unproductive assets
d) Negotiate with suppliers to ensure a longer cycle
e) Negotiate with buyers to ensure a shorter cycle
f) Weed out any less important customers who delay or default on payments
g) Manage short-term debts properly
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. Business Loan disbursal is at the sole discretion of Poonawalla Fincorp.
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Our team of expert writers and editors are passionate about providing authentic and valuable information on finance. Our aim is to simplify financial and finance-related concepts. We strive to help our readers become more aware and empowered to make informed financial decisions.
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