What is working capital? – It is the cash or cash equivalent in the business which can help fulfil the short term capital requirement for operational activities or to ensure business as usual.
What is Working capital and why is it important?
As highlighted earlier, it is the cash or cash equivalent that helps the business fulfill its short term commitments to ensure smooth operations of the business.
It is important in various aspects. Be it operational or financial, sufficient working capital ensures that the business is in a solid position.
Now that we know that working capital is an essential part of smooth operations of a business, it is also important to know how to calculate the same!
Working capital can be calculated as : WC = Current assets – Current liabilities
However, it is important to know what can be included under current assets and current liabilities.
Current Assets:
- Cash : It is the most important part of the current assets side of the balance sheet. It is a determinant for the cash position of the business and how easily and quickly can a business pay its short term liabilities
- Bills receivable : It is the cash that the business is yet to realize from its customer for products or services that has already been delivered to the customers
- Inventory : It is the stock in hand which is ready to be delivered to the customers upon orders, healthy levels of inventory has a positive impact on the operational efficiency of the business
- Marketable securities : These are financial instruments that can be readily sold in the financial markets for a cash consideration. These are highly liquid form of assets
- Prepaid Expenses : Prepaid expenses are the expanses that the business is yet to incur, however they’ve paid for the same in advance
- Other Liquid assets : Other liquid assets include securities and instruments that can readily be exchanged for cash consideration
Current liabilities:
- Accounts Payables : These are the bills that the business is yet to pay off for the products and services that the business purchased from their vendors
- Tax Payables : As the name suggests, these are tax liabilities that the company is yet to pay off
- Accrued expenses : Accrued expenses are those that the business has incurred but has not paid yet
- Short term debt : Short term debt is the debt liability which is due to be paid back in the short term or the next 1 year. This can also be a part of a long term debt liability that is due in short term
- Unearned revenue : It is the cash consideration that the business has received for the products and services that the business is yet to deliver to its customers
- Dividends payable : Dividends are a part of the profit that is paid back to the shareholders, it is an important part of current liabilities
Key benefits of maintaining adequate working capital!
Maintaining adequate working capitals can have numerous direst short term benefits, as well as various indirect long term benefits. These act as determinants of working capital management being efficient. Some of the benefits are explained below:
- Operational Efficiency : It helps the business to achieve efficiency in operations
- Expansion Opportunities : adequate working capital gives headspace to the business to explore expansion, as day to day operations are covered
- Enhanced Debt Management : Adequate liquidity helps the business to manage the debt effectively
- Liquidity : Adequate working capital enhances liquidity of the business thus enhancing its capacity to pay short term obligations
Types of Working Capital!
- Based on Timeframe
- Based on Components
- Based on Functions
Factors that determine the requirement of Working capital
Working capital requirements can be dynamic and depends on various factors. Following are the factors determining working capital needs:
- Nature of Business : Different businesses may have different liquidity needs. For cash heavy businesses, it is essential to have more liquidity to ensure smooth operations, hence nature of business is one of the key determinants of working capital requirements.
- Scale of Operations : It is the scale at which the business operates. For businesses operating at a bigger scale, the liquidity requirement would be high considering the need for more capital to fund the ongoing operations
- Operating cycle : It is one of the most important factors that help in determination of working capital requirements. Businesses with longer operating cycle need to have more liquidity available to ensure that while the bills receivable are still pending, the business operations are not taking a hit
- Seasonal Demand : It affects the short term requirement of liquidity, as surge or a drop in demand may result in high or low working capital requirement respectively
How to apply for a Working Capital loan?
- Assess and determine your working capital needs : The business first needs to make an assessment of the shortfalls that can be fulfilled with more working capital, essentially determining the reason and how much more working capital can be injected into the business, management can do a working capital gap calculation to come to a suitable number
- List down options how you can secure a working capital loan : The entrepreneur should then list down the options they have that can help them secure more working capital. There are various companies that offer working capital loans at favourable interest rates and repayment terms, most suitable for small businesses
- Complete the application process : Once, everything is place, put together the required documentation, and complete the application process to secure working capital
Conclusion
Working capital is the most important cash or asset of a business that helps meet short term obligations, and thus ensures smooth operations. It is calculated as current assets minus the current liabilities. There are various factors affecting the requirement of working capital like nature, scale, operating cycle, and seasonal demand of the business. Working capital improves operational efficiency, liquidity, and expansion opportunities.
Understanding and managing working capital is important to ensure smooth business operations by meeting short term obligations. Management must be proactive to ensure liquidity and growth. Businesses need to assess their working capital needs and look for appropriate financing options to sustain in the long run.
Frequently asked questions:
What is the Ideal amount of working Capital for a small business?
It depends upon various factors like nature, scale, industry, etc. of the business. Entrepreneur can leverage a working capital gap calculator to get a more tailored estimate
How does working capital impact profitability?
Working capital has an impact on various aspects of the business, more importantly the operational efficiency of the business, which is a great contributor to profitability
What is the difference between Gross and Net Working Capital?
Gross working capital is the total value of all the current assets of the company, while net working capital is the value of current assets minus the current liabilities of the business
Can businesses survive without a positive working capital?
Although the business can survive without a positive working capital, however the survival will be short lived as any organization requires enough capital to sustain operations and thrive in the long run
What are the common challenges in managing working capital?
A business can face common challenges like seasonal fluctuations in demand, externalities that may drain the company of cash, longer than usual credit and business cycles, among other factors
