Let’s Understand Working Capital in Detail
Working Capital is one of the most important components of business. Businesses cannot think of functioning without sufficient working capital to meet their day-to-day needs. Insufficient working capital amounts to a shortage of resources. Whereas excessive working capital results in increased cost for the business.
Thus, it is important to have an optimum quantity of working capital to run a business. This means working capital should neither be more nor less than the amount actually required by the business. Furthermore, you must evaluate the return on the number of funds invested in the business in the form of working capital. Such a return should be at least equal to the return earned by the business in case it invested funds in other avenues.
Many times, businesses fail not because of a lack of profits but because of insufficient funds required to run its day-to-day operations. Thus, working capital management plays an important part. This is because it greatly impacts the liquidity and profitability of the business. So you need to ascertain the amount of working capital needed and the sources of financing such a capital. This is to ensure that the working capital available is sufficient to meet the short term obligations of your business.
Therefore, let’s have a look at the meaning of working capital, its importance and the factors that impact the working capital of your business.
What is Working Capital?
Working capital is defined as the excess of current assets over current liabilities. It forms a part of the aggregate capital of the business. Now, a business needs working capital to fund its short term obligations. Typically, firms with an optimum level of working capital indicate efficiency in managing its operations. This further enables the firm to pay for its short-term dues and day-to-day operational expenses.
Therefore, working capital is a measure of business’ liquidity position, operational efficiency, and short-term financial soundness.
Hence, working capital can be put into the following equation:
Working Capital = Current Assets – Current Liabilities
So, let’s have a look at what forms current assets and current liabilities of a business in order to understand the above equation.
Current Assets are the assets of the business that can be easily converted into cash within a year or normal operating cycle of the business, whichever is greater. These assets typically include:
Current Liabilities are the obligations of the business that are due within one operating cycle or a year, whichever is greater. Such liabilities are paid off by either using the current assets of the business or by creating other current liabilities.
Therefore, Current Liabilities include:
- Accounts Payable
- Notes Payable
- Current Portion of Long Term Debt
- Accrued Liabilities
- Unearned Revenues
Types of Working Capital
Depending upon the Periodicity & concept working capital can be classified as below:
- Permanent Working Capital
- Regular Working Capital
- Reserve Margin Working Capital
- Variable Working Capital
- Seasonal Variable Working Capital
- Special Variable Working Capital
- Gross Working Capital
Net Working Capital
Permanent Working Capital
It is that portion of the working capital that remains permanently tied up in current assets to undertake business activity uninterruptedly. In other words, permanent working capital is the least amount of current assets needed to carry out business effortlessly. Thus, it is also known as fixed working capital.
The amount of fixed working capital required by a business depends upon the size and the growth of the business. For instance, minimum cash or stock required by a firm to undertake the operational activities of the business.Now, permanent working capital can be further subdivided into two categories:
Regular Working Capital
This is defined as the least amount of capital required by a business to fund its day-to-day operations of a business. Examples include payment of salaries and wages and overhead expenses for the processing of raw materials.
Reserve Margin Working Capital
Apart from day-to-day activities, a business may need some amount of capital for unforeseen circumstances. Reserve Margin Working Capital is nothing but the amount of capital kept aside apart from the regular working capital. These pool of funds are kept separately for unforeseen circumstances such as strikes, natural calamities, etc
Variable Working Capital
This can be defined as the working capital invested for a temporary period of time in the business. For this reason, it is also called as fluctuating working capital. Such a capital varies with respect to the change in the size of the business or changes in the assets of the business.
Further, variable working capital is subdivided into two categories
Seasonal Variable Working Capital
This refers to the increased amount of working capital a business needs during the peak season of the year. A business may even have to borrow funds to meet its working capital needs. Such a working capital specifically meets the demands of business having a seasonal nature.
Special Variable Working Capital
Supplementary working capital may also be required by a business to undertake exceptional operations or unforeseen circumstances. The capital required for such circumstances is termed as special variable working capital. Funds needed to finance marketing campaigns, unforeseen events like accidental fires, floods, etc
Gross Working Capital
This refers to the aggregate amount of funds invested in the current assets of the business. In other words, Gross Working Capital is the total of the current assets of the business. These include:
- Accounts Receivable
- Marketable Securities and
- Short-Term Investments
Gross Working Capital used alone neither shows the complete picture of the short-term financial soundness. Nor does it showcase the operational efficiency of the business. Current assets should be compared with the current liabilities to get a better understanding of a business’s operational efficiency. That is, how efficiently a business utilizes its short term assets to meet its day-to-day cash requirements.
Net Working Capital
Net Working Capital is the amount by which current assets exceed the current liabilities of a business. Thus, the working capital equation is defined as the difference between current assets and current liabilities. Where current assets refer to the sum of cash, accounts receivable, raw material and finished goods inventory. Whereas, current liabilities include accounts payable.
The amount of working capital in a business is the indicator of liquidity, operational efficiency and short-term financial soundness of the business. Businesses having adequate working capital typically have the ability to invest and grow.
On the other hand, businesses having insufficient working capital have higher odds of going bankrupt. This is because of their inability to pay for their short-term obligations, thus making it difficult for them to grow.
Factors Determining Working Capital
1. Nature and Size of Business
The working capital need of a business depends a great deal on its nature and size. Let’s consider various types of businesses to understand how the nature of business impacts its working capital requirements.
When it comes to trading firms, they require less amount of money to be invested in fixed assets. However, a huge pool of funds needs to be invested in the form of working capital. On the other hand, retail stores must keep a large quantity of inventory to meet the diversified and continuous needs of its customers.
Similarly, the need for working capital in manufacturing firms varies between small to a substantial amount. This working capital amount depends upon the type of business a firm is into. Likewise, public utility firms require less working capital but invest heavily in fixed assets. This is because they have cash sales only and supply services over products. Hence, they have fewer funds blocked in current assets such as debtors and inventories.
Finally, the size of the business also impacts the working capital needs of the business. Firms with large scale operations need more working capital as compared to smaller firms.
2. Business Cycle
Business cycle too has a significant impact on the working capital needs of a business. During the boom phase of the business cycle, businesses typically tend to expand thus requiring additional working capital. These periods of increased business activity require additional funds to meet the time lag between collection and sales. Further, funds are also needed to purchase additional raw material needed to produce additional goods for increased sales.
Not only that, the peak period leads to the increased prices of raw material and increased wages. Thus, additional funds are needed to provide for such operational expenses.
In contrast, there is lesser demand leading to both the decline of production and sale of goods during periods of depression. Thus, less amount of working capital is required by the business to carry out its operational activities.
3. Production Cycle
Production cycle, also known as the operating cycle, is the time difference between the conversion of raw materials into final products. This too impacts the working capital requirements of a business to a greater extent.
Businesses with longer production cycles need more working capital to fund its operational activities. Therefore, firms adopt various measures to reduce their production cycle in order to minimize their working capital requirements.
4. Seasonal Fluctuations
There are certain businesses that are seasonal in nature. This means there is a high demand for their goods during a specific period of the year. In such cases, inventory of raw material needs to be purchased during a specific period of time. This is done so that goods are produced and are offered for sale when they are needed.
Thus, the need for inventory increases during this period as compared to the other periods of the year. Therefore, businesses need additional funds to purchase inventories during the specific time of the year. As a result, the seasonality of business impacts the working capital requirements of the business.
5. Operational Efficiency
Various businesses operate on different operational efficiencies. Thus, the operational efficiency of a business depends upon various factors. These include:
- Short production cycles that involve less time to convert raw material into finished goods
- Achieving sales quickly
- The shorter debt collection period
Thus, businesses with increased operational efficiency are required to invest a lesser amount of funds in working capital. In contrast, businesses that have lesser operational efficiency need more funds to be invested in working capital.
Here is an infographic that explains what is working capital and working capital cycle in an easy to understand way.