Working Capital could certainly be considered the lifeline of a business; equivalent to the fuel that keeps the car running.
The ability of a business to fulfill its orders, the credit obligations of a business, retaining talented employees, its competitiveness- all are directly related to how a company manages its working capital.
A need then arises, to understand what working capital is, its importance, what it is used for, the sources of working capital financing, and how to optimise its management.
What is Working Capital?
Working Capital is the capital required for the day-to-day functioning of an enterprise. It is also called Short-term Capital or Current Capital and represents the total Current Assets an enterprise possesses to fulfill its short-term obligations.
When the liquid resources of an enterprise are used to finance its short-term liabilities, it gives us Net Working Capital.
Thus, the formula for calculating an enterprise’s Net Working Capital is-
Net Working Capital = Current Assets – Current Liabilities.
The Working Capital of an enterprise helps in understanding its liquidity position.
A Positive Net Working Capital represents that the Current Assets of an enterprise are more than its Current Liabilities. This signifies that the firm has enough capital to cover its short term liabilities.
A Negative Net Working Capital represents that the Current Liabilities of an enterprise are more than its Current Assets. This signifies that the firm may not have enough liquid assets to cover its short-term liabilities.
Also Read: What are Different Types of Working Capital? All Explained
Components of Working Capital
The components of Working Capital are its Current Assets. These are assets of an enterprise that are highly liquid, ie. the assets that can be quickly converted into cash and its equivalents.
Such assets are of various types-
- Cash in hand– This is the capital available with the enterprise as fiat money or bank balance.
- Cash equivalents– This includes instruments that can be readily sold in the market to convert them into cash. Example- Treasury bills, Commercial Paper, etc.
- Accounts Receivable– This includes the debtors of an enterprise from whom money is to be received. Example- Bills of Exchange.
- Inventory– This is the stock of goods an enterprise holds that can be sold to convert it into cash within the fiscal year.
- Prepaid Expenses and other liquid assets– This includes assets for which payment has been made but the assets are yet to be received.
What can Working Capital be used for?
Working Capital is often used to finance the operational requirements of a firm. It provides the resources for its day-to-day functioning. Thus, it could be used in the following ways-
Purchasing Raw Materials– A firm needs raw materials for processing the products it offers. Working Capital is used to procure the inputs that need to be processed by the enterprise.
Upgrading Machinery– Working Capital could be used for upgrading the equipment or machinery to stay competitive.
Marketing Campaign– It could be used to fund marketing campaigns and reach out to new customers.
Hire new staff– It could be used for Human Resource Management which includes hiring new staff or persons with expertise.
Renovations– Working capital could be used for renovation or upkeep of the office space.
Digitalisation of Business– It could be used to purchase software or hardware to digitalise the business.
Tackle payment delays– Working Capital bridges the gaps in transactions with immediate funds and mitigates the risks associated with late payments.
Working Capital is also used to finance the Current Liabilities of a firm. These are liabilities of an enterprise that must be repaid within a fiscal year (12 months). Thus, it represents the capital required by an enterprise to pay off its obligations in the short term.
Such liabilities are of the following types-
- Wages/Salaries– This includes money to be paid to the employees as salary/wages. Timely payment of wages helps in the retention of talent, allowing an enterprise to be competitive.
- Accounts Payable– This includes money to be paid to the operational creditors of an enterprise. These are usually sellers or a firm providing any service to the enterprise.
- Outstanding Loans– This includes loans taken by a firm that must be repaid in the short-term. This may also include long-term loans maturing within the fiscal year. To
- Accrued Interest– This includes interest accrued on loans and other debt instruments.
- Bank Overdrafts– This includes outstanding Overdrafts of an enterprise.
- Dividends Payable– This includes dividends announced by a company for its shareholders that must be distributed in the fiscal year.
- Accrued Expenses– This includes expenses accrued within a fiscal year. This may include utility bills like electricity bills, water consumption bills, transportation costs, etc.
- Tax Obligations– This includes the tax liability of the business.
Importance of Working Capital
The Working Capital of a firm reflects its capacity to meet its immediate and medium-term obligations and thus, is essential to gauge the health of a business.
In a dynamic business environment, wherein an expenditure may arise without being planned for, it is pertinent to maintain a healthy working capital- a Positive Net Working Capital.
A positive Net Working Capital often reflects the excess assets a firm has to cover its current liabilities. Thus, it often depicts idle funds, or a buffer to absorb unforeseen losses.
The working capital of a company is important because of the following reasons, among many-
Maintains the creditworthiness of a company– Timely repayments of loans and interest accrued, both of which are paid out of the working capital of a company helps in maintaining a good credit score.
Keeps the morale of the workforce high– Timely payment of salaries/wages keeps the employees motivated to function effectively.
Shock-absorbing capacity– A positive working capital has the shock-absorbing capacity to meet unforeseen obligations.
Ensures efficient operations– A healthy working capital of a firm ensures that it has the requisite funds to finance its operations.
Boosts Goodwill– Timely payments of dividends announced increase the goodwill of the firm.
Buffer for a lean season– The sales of a firm may not be consistent or have seasonal variations. The working capital in such cases allows the enterprise to function during those periods and prevents it from shutting down.
Sources of Working Capital Financing
Given the importance of Working Capital, various products are offered by Financial Institutions to allow firms to have requisite funds for their working capital requirements. A few most commonly used instruments used for financing Working Capital is-
Working Capital Loans– Banks/NBFCs often give loans with a tenure ranging from 6 months to 48 months.
Overdraft Facility/Line of Credit– Financial Institutions often sanction a borrowing limit to firms in their Current Accounts to iron out their cash flow inefficiencies. A firm could borrow an amount within that limit as many times as required and pay as per their convenience.
Invoice Discounting– Even though Outstanding Invoices are part of the Current Assets and are taken in consideration while calculating the Working Capital of a firm, an invoice in itself is futile unless converted into cash to fund the operations of a company. Thus, Financial Institutions offer discounting facilities that provide enterprises with advances against their outstanding invoices.
Also Read: Exploring Different Sources of Working Capital Finance
Ways to optimise the Working Capital
The health of the Working Capital of a company is often gauged with its Current Ratio.
The Current Ratio, also known as Working Capital Ratio is the ratio of a firm’s Current Assets to its Current Liabilities. Thus, it signifies its ability to meet its short-term obligations with the liquid assets the enterprise has.
To enhance the Working Capital Ratio, or simply, optimise the Working Capital, a firm could take the following steps-
Preference to long-term debt over short-term debt– This does not increase the short-term liabilities of an enterprise and also makes the repayment affordable with longer tenure.
Converting idle illiquid assets to cash– Idle illiquid assets can be sold to acquire cash-in-hand, enhancing a company’s working capital.
Inventory Management– A good inventory management ensures the money is not locked up in the stock and can be utilised efficiently. The parameter to reckon a firm’s inventory management is Inventory Turnover Ratio, which reflects the ability of an enterprise to manage its inventory.
Reduction in redundant expenses– Unnecessary expenditure can be reduced to ensure better utilisation of funds.
Conclusion: Working Capital- The wheels running the machine.
Working Capital serves as the primary means to ensure that an enterprise functions efficiently irrespective of the economic cycle.
It has various uses that cover the whole ambit of the operations of an enterprise. To recapitulate its essential uses, it not only provides the resources for expenditure, but also acts as a buffer for contingent liabilities or lean seasons of a business.
It is then important to keep a healthy working capital ratio for enterprises, which could be done by either reducing the short-term liabilities, or converting illiquid assets to liquid assets.
FAQs
What is working capital in simple words?
In simple words, Working capital is the money required by companies to function. It is the resources a company has for its operational expenditure.
Which is the best example of working capital?
Cash and its equivalents to be utilised for financing operations of a firm is one of the most relevant examples of working capital.
What comes under Working Capital?
The Working Capital of a company consists of its Current Assets. It consists of-
- Cash and its equivalents
- Inventory
- Accounts Receivable
- Prepaid Expenses
What are the 5 sources of Working Capital?
5 sources of Working Capital, among several others are-
- Bank Loans
- Invoice Discounting
- Line of Credit
- Trade Advances
- Commercial Paper
How to calculate Working Capital?
The formula to calculate Net Working Capital is-
Net Working Capital = Current Assets – Current Liabilities
