All You Need to Know about Working Capital

18 Sep 2020

All You Need to Know about Working Capital

If you run a business, then one of the most common terms that you would have come across is working capital. It is essential to manage day-to-day activities, and that’s why a good amount of working capital is mandatory for any company. You need it to pay off the bills, salaries of employees, short term debts and manage other expenses. It becomes imperative for companies to maintain a healthy working capital which is also an indicator of the good financial health of the company.

What is working capital?

Let us understand what working capital is. It is an indicator of the liquidity levels of companies to manage day-to-day expenditure. It covers cash, account payable, accounts receivable, short term debt, inventory, etc. to name a few. A company’s operations like inventory management, debt, supplier payment and collection of revenues contribute to working capital.  

Breaking down various aspects of working capital:

Sources of Working Capital

Working capital sources can be of any of the following types:

  • Short-term working capital – Short-term working capital sources includes public deposits, cash credit, short-term loans, commercial papers, tax provisions, inter-corporate loans, etc.
  • Long-term working capital – The sources for long-term working capital consists of retained profits, debentures, long-term loans and share wealth.

Types of Working Capital

Working Capital is based on a balance sheet or operating cycle view.

As per the balance sheet view, the working capital can be:

  • Net: current assets- current liabilities
  • Gross: it includes current assets in the balance sheet

Working Capital as per operating cycle:

  • Temporary: It is the difference between net working capital and permanent working capital.
  • Permanent: Fixed assets.

Note: The temporary working capital can further be sub-divided into reserve and regular working capital.

Working Capital Cycle

Working Capital Cycle or WCC is the period that any organization takes to convert the current liabilities and assets into cash. WCC indicates the financial health of any organization. The shorter is the period of the working capital cycle; the better is the financial health of the company. It measures how efficient the organization is in managing the liquidity position in the short-term. It is measured in days. To sum in simple words, the Working Capital Cycle is the difference of time between period for revenue generation through cash by selling products and buying of materials for producing these products.

If an organization has a shorter working capital cycle, then the company is more efficient and can free up its cash which is on hold. Every company aims at having a lower working capital cycle to enhance liquidity in the short term.

Working Capital Formula

Working Capital = Current Assets - Current Liabilities

Positive and Negative Working Capital

Two parameters showcase the financial health of the company with the perspective of working capital:

  • Positive working capital - A company having positive working capital is always good. It shows that the company can meet the business expenditure and finance its growth without relying on loans and raising funds.

  • Negative Working Capital- If the company has a negative working capital, it means the company doesn’t have enough liquid assets to meet its short term or current obligations. It results because the company doesn’t have sufficient cash flow. In such cases, the company will have to liquidate money or borrow it which will increase the liability on the company.

As a flourishing organization, you need to know that a company should have positive working capital. In case your company has a negative working capital then it might push you to take loans which will put you in debt. Thus, maintain a positive working capital becomes imperative for any organization.

What is the working capital ratio?

This brings us to another term, working capital ratio. This is also favoritely known as the current ratio. It is the liquidity ration that measures a company's ability to pay its current liabilities with current assets. We can say that working capital ratio is the indicator of liquidity of the company.

Working Capital Ratio= Current Assets / Current Liabilities                                        

What does working capital ratio indicate?

Working Capital Ratio is also an indicator of the financial health of the organization. It shows whether the company has enough short-term assets to meet short-term debt.

  • Working Capital Ratio less than 1- It shows that the company has negative working capital. It will thus be difficult to find ways to manage funds during the crisis.
  • Working Capital Ratio between 1.2 and 2.0- It is positive and shows that the company has enough funds to meet short-term debts.
  • Working Capital Ratio more than 2- It shows that the company has excess assets which are not being invested somewhere, and thus shows a lack of management and the company has missed an opportunity.

For every organization, it becomes imperative to have a healthy working capital ratio. The negative means that assets are not increasing and the company is getting burdened under liabilities. It reflects that the company is inefficient and doesn’t have enough resources to make money. When it comes to settling the obligations, then the money which is locked in the market, or is stuck with the customers who haven’t paid must be considered feasible.

Once you have calculated your working capital you must get the required funds if necessary. There are various ways to achieve this, you may need to speed up your collection process, borrow funds and also go for crowdfunding if your company is a start-up. Whatever be the case, it is vital for any organization to have sufficient working capital, so that it can seamlessly manage its day-to-day operations.

Conclusion

Your company needs sufficient working capital to thrive. It’s the short-term financial position of the company. Nowadays you can easily find banks and NBFCs who readily provide a working capital loan to the company. Crowdfunding has emerged as a favorite way to raise funds. It has become the most common way via which the start-ups can easily get funds to execute their business plan and run their business operations with ease.

Afinoz is here to help you avail business loan. For further assistance, give us a call at +1 (925) 317-8255