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What is Working Capital and its Benefits?

11 Jul 2019

You only need an idea, a product or a service to start a business. However, as your venture begins to grow, it is crucial that you start getting acquainted with many other aspects of running a business. One of them being the Working Capital.

The backbone of any business – the working capital, is as important as the product or the service itself. Obtained by subtracting the current liabilities from the current assets, it is an important feature of the business as it indicates an enterprise’s liquidity, operational efficiency, short-term financial position as well as its overall efficiency.

What is Working Capital?

An enterprise has assets, such as cash, accounts receivable (customers’ unpaid bills), inventories of raw materials and finished goods, as well as liabilities, such as accounts payable. Also known as net working capital (NWC), working capital is the difference between the two.

A company with substantial working capital has the potential to invest and grow. Whereas, a company faces trouble growing or paying back creditors when its current assets do not exceed its current liabilities.

Types of Working Capital

  • Gross Working Capital:
    The total funds invested in current assets which can be easily converted into cash within a time period of one year, it includes cash in hand and at bank, debtors, bills receivable, short term securities, prepaid expenses, accrued expenses and inventories like raw mate­rials, stores and spare parts, work-in-progress, and finished goods.
  • Net Working Capital:
    The excess of current assets over current liabilities, it is the amount of current assets that remain in a firm after all current liabilities like bills payable, outstanding expenses, short-term loans, advances and deposits, sundry creditors, bank overdraft, proposed dividend, provision for taxation etc. are paid.
  • Regular Working Capital:
    Permanent working capital normally required for the working capital cycle to flow smoothly in the normal course of business.
  • Reserve Working Capital:
    Available over and above the regular working capital, it is often kept for contingencies which may arise due to unexpected situations.
  • Temporary Working Capital:
    The fluctuating capital derived from the difference between net working capital and permanent working capital which cannot be forecasted.

Sources of Working Capital

  • Spontaneous Working Capital, majorly derived from trade credit including notes payable and bills payable.
  • Short-term Working Capital, includes dividend or tax provisions, cash credit, short-term loans, bills discounting, inter-corporate loans, public deposits, trade deposits, and commercial paper.
  • Long-term Working Capital, includes long-term loans, retained profits, debentures, provision for depreciation, and share capital.

What can Working Capital be Used For?

The purpose of working capital is to keep a business operating smoothly and meet all its unexpected expenses and financial obligations within the coming year.

Here are a few things working capital is used for –

  • Paying creditors on a timely basis
  • Having a cash reserve
  • Managing short-term debts
  • Maintaining an optimum level of inventory
  • Meeting unforeseen or unpredictable expenses
  • Meeting miscellaneous day-to-day business expenses

 

Working Capital Formula

Working Capital Formula

What is Working Capital Ratio?

The working capital ratio is the number derived from the working capital formula and indicates the following,

  • Ratio of less than 1.0, indicates a negative working capital where the company’s current liabilities exceed its current assets
  • Ratio of 1.0, indicates that a company’s current assets are equal to its current liabilities
  • Ratio of 2.0. Indicates that the company has twice the amount of current assets as current liabilities
  • Ratio between 1.1 and 2.0, indicates that the company is managing its cash wisely and minimizing its risk of defaulting on its bills
  • Ratio of more than 2.0, indicates relatively low cash amount and also indicates that the company is slow at moving its inventory and collecting its receivables, and is quick at paying its vendors

What is Working Capital Cycle?

The working capital cycle is the time taken by any organization to convert its net current liabilities and assets into cash. The WCC is also an indicator of a business’s efficiency in terms of effectively managing liquidity position in the short-term. It is essential and preferable for a business to keep this cycle as short as possible to free up its cash.

What is Working Capital Management?

The working capital formula, in reality, is an indication towards if the company can liquidate its current assets to pay current liabilities. However, it is not always realistic for an enterprise as they always require some cash to meet operational obligations such as payroll. Moreover, asset purchases, payment and collection policies, writing off past-due receivables, capital-raising efforts, and more such factors also impact the working capital.

For a business to pay its dues on time and stay in profit, the level and timing of a company’s cash flows is a determining factor. Working capital management refers to overseeing and controlling these cash flows effectively so that it does not outgrow itself of cash by needing more working capital to fulfil expansion plans.

Advantages and Disadvantages of Working Capital

Having adequate working capital at all times can have many advantages, as well as a few disadvantages. Let’s learn about them here –

Advantages of Working Capital:

  • Helps bridge payment delays and manage cash flow for crucial operating expenses like payroll, keep utilities running, pay for lease or mortgage, etc.
  • Useful to buy the additional inventory required to fill future orders, restock your inventory, purchase new products, etc. or expand the infrastructure of the business.
  • Useful in upfront payment when you want to take advantage of bulk pricing to update equipment.
  • Ideal for seasonal businesses for restocking inventory, hiring temporary employees, boosting preseason marketing, etc. Also helpful during cash crunch in the off-season to cover expenses like rent, insurance, taxes, utilities, salaries, etc.
  • Working capital is helpful to fund a marketing campaign to attract new clients, refresh a brand, increase their online presence, event sponsorship, direct marketing campaigns, etc.
  • Especially useful to meet unexpected and unforeseen expenses.

Disadvantages of Working Capital:

  • The excess working capital lying with the company earns no interest for the company.
  • There are chances of overspending or purchasing unnecessary things for the business.
  • Companies tend to use the working capital for financing long-term projects.

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