Working capital is the capital or funds available to a company for its day-to-day operations. It represents the difference between a company's current assets and current liabilities, providing insight into its short-term financial position. Paying attention to working capital allows businesses to assess their ability to produce cash flow, that is, liquidity. In addition, it allows for manoeuvring assets and liabilities in a balanced way. The article discusses the concept of working capital, why it is important, and how working capital is calculated for businesses.
- What Is Working Capital?
- Sources of Working Capital
- What Does The Working Capital Indicator Measure?
- Working Capital Formula
- Factors Affecting Working Capital
- Importance of Working Capital
- Reasons Your Business May Require Additional Working Capital
What is Working Capital?
Working capital is the amount of available capital that a company can use to meet payment commitments in the short term and in day-to-day operations.
This indicator is similar to the solvency index, allowing you to see the relationship between your assets and liabilities to know your operating margins.
Working Capital Components
The two components of working capital are:
Sources of Working Capital
The main sources of working capital include –
- Sales through positive company results
- Financing without debt
- Capitalization through the entry of new partners
What Does The Working Capital Indicator Measure?
Working capital shows the balance between the assets and liabilities of a company. Thus, you can indicate if it has what it takes to trade before making a profit. That is, it shows if a company has enough money to cover the expenses that allow it to profit.
- Working capital is important because the company’s capital must be known if an investment or greater expenses are required.
- Working capital is usually the necessary resource for a company or financial institution to carry out its operations. That is, the assets for a company to carry out its functions and activities in the short term.
- The working capital shows a company’s balance between assets and liabilities (debts or payment commitments). Therefore it is an indicator of whether it has enough to operate before making a profit.
- Working capital is essential to know the course of a business, in case you want to make an investment or essential expense or to improve the company’s administration.
Working Capital Formula
To know the working capital necessary for the regular operation of your business, you have to know your monthly income and subtract your passive expenses. Although there are different proportions according to the category and type of business, the fundamental thing is that the assets are more significant than the liabilities.
The formula to calculate working capital is –
Working Capital = Current Assets + Current Liabilities
Let’s understand this better through the below calculation –
It is essential in this calculation to only consider short-term income, such as accounts receivable and cash on hand, and at most, sales that are expected to be completed in less than 12 months. As for liabilities, all recurring expenses should be considered, such as accounts payable, taxes, materials, salaries, etc.
Factors Affecting Working Capital
Due to their size and structure, small companies have a series of limitations since they enjoy a different degree of financial stability and operational efficiency than competitors with greater economic and technological capacity. Therefore, it would be essential that the asset items in which specific amounts of capital are invested, such as accounts receivable, inventory, and accounts payable, are well managed to maximize the profitability of these investments.
The items that make up the Working Capital, such as cash, temporary cash investments, accounts receivable, and inventories, are affected by different factors, varying in amount. The Working Capital needs of a particular business depend on the following:
The line of business determines the need for Working Capital since not all companies will need the same proportion of working capital. For example, an industrial company will require more working capital than a service company since The industrial sector will need more significant investment in raw materials, production in process, and particular articles.
Time required to obtain the merchandise and its unit cost
The longer the time required to manufacture or obtain the merchandise, the more significant the working capital will be. This varies depending on the unit cost of the merchandise sold.
Due to its investment in operating costs, inventories, and accounts receivable, there is a direct relationship between the volume of sales and the need for working capital. It is logical that as the volume of operations expands, the amount of working capital required will be greater, although not necessarily in exact proportion to the growth.
The merchandise purchase conditions determine whether the working capital requirements are higher or lower. The more favourable the credit conditions under which purchases are made, the less cash will be invested in inventory.
Inventory Turnover and Accounts Receivable
The greater the number of times that inventories are sold and replaced, the lower the amount of working capital needed. The high turnover of inventories must be accompanied by a high turnover of accounts receivable so that the Working Capital is not immobilized and is thus available for use in the operations cycle.
Risk of a drop in the value of Current Assets
A drop or decrease in the actual value compared to the book value of marketable securities, inventories, and accounts receivable will result in decreased working capital; then, the greater the risk of a loss, the greater the amount of working capital that must be available to maintain the company’s credit.
Importance of Working Capital
It is important to note that a company can have a high stockholders’ equity and not simultaneously have a similar working capital. The opposite case would also happen. This non-dependence will have to do with the conformation or structure of the company’s assets and liabilities.
For example, a company may have much real estate within its assets but must avoid various short-term payments as it does not have constant monetary returns. This is common in times of crisis or lack of liquidity.
Reasons Your Business May Require Additional Working Capital
Your business may require additional working capital at any time. Some of the most common reasons are listed below –
Seasonality – Seasonality is one of the most common reasons for needing additional working capital. Many companies from different segments have high and low seasons and sometimes sustain themselves during those low months, thanks to good times. In those peak seasons, accessing additional working capital also allows you to cover hiring external services or temporary employees. Seasonal differences in cash flow can happen with any business, which may need additional capital to prepare for a peak season or keep the business running when less money is coming in.
Higher Waiting Periods – Another common reason that justifies a capital injection is when the company must wait for some customers to meet their payments in 60, 90, or more days, which puts the business in a difficult situation since it must meet obligations such as salaries or taxes.
Financial Obligations – Almost every business requires additional working capital at some point to meet financial obligations to suppliers, employees, and the government while waiting for customer payments.
Business Development – The additional working capital aids help improve your business in other ways, such as allowing you to take advantage of supplier discounts when buying in bulk. Working capital also supports paying temporary employees or covering other project-related expenses.
If a company’s working capital is negative, it means that the company cannot service its debt. In contrast, positive working capital means you can afford your operations and meet your obligations while having enough room to launch growth strategies.
However, it is important to mention that too high a level of working capital is only sometimes desirable; it also indicates that the business has too much inventory or needs to invest its cash properly.
FAQs - Working Capital
Why is working capital important for a business?
Working capital is essential because it ensures a company can meet its short-term financial obligations and continue its operations. It also indicates a company's financial health and liquidity.
What does a positive working capital signify?
A positive working capital indicates that a company has more current assets than current liabilities, which means it has the resources to cover its short-term obligations and invest in growth opportunities.
How can a company improve its working capital?
A company can improve its working capital by increasing its current assets, reducing its current liabilities, optimizing inventory management, collecting accounts receivable more efficiently, and controlling operating expenses.
What are some common sources of working capital for a business?
Common sources of working capital include cash reserves, short-term loans, lines of credit, and proceeds from the sale of assets.
What are the risks of having excessive working capital?
Excessive working capital can mean a company needs to use its resources more efficiently. It may miss investment opportunities, and the excess cash might not earn a reasonable return.
What happens if a business runs out of working capital?
If a business runs out of working capital and cannot meet its short-term obligations, it may face financial difficulties, including bankruptcy or insolvency.
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