Working Capital
Every venture needs capital to meet all the business needs, be it gathering the resources or injecting capital into day-to-day activities. The capital required by a business or venture to meet its day-to-day expenses is known as the working capital. Working capital is often also known as short-term capital decisions.
Working capital revolves around two important components of a business, which are, current assets and current liability. The assets that is capable of being converted into cash within one year. Moreover, are extremely liquid, are called current assets of the business. For instance, bank balance, cash in hands, short-term investments, debtors, and prepaid expenses.
Another component of the working capital is the current liability. Current liabilities are the sum of amounts due to be paid within the span of a year. For instance, bank overdrafts, outstanding expenses, etc.
The net working capital is the difference between the current assets and the current liabilities of the company.
What is Working Capital?
The difference received after deducting the current liabilities from the current assets is known as the net working capital of the business. Working Capital is the measure of a venture's liquidity. It also denotes the operational efficiency of a venture. The better the working capital, the better is the business’ short-term financial health.
Concept of Working Capital
The concept of working capital is simple. It is the capital that a business uses to meet its daily expenses and is considered to be the most liquid part of the total capital. Working capital is also known as Net Working Capital (NWC).
This is derived by comparing the current assets with the current liabilities on the balance sheet. The difference derived is known as the working capital of the company.
- The working capital of a company reflects the difference between the venture's current assets and liabilities. It is also represented as NWC or Net Working Capital of the company.
- Net Working Capital (NWC) estimates the liquidity of the company.
- It also assesses the company's short-term financial health.
- The company's NWC is considered to be negative if the ratio of current assets to the current liabilities falls below one. In simpler terms, the ratio should be one or more to reflect the positive working capital.
- A positive Net Working Capital or NWC indicates the capability of the business to fund the future as well as the current operations. It is also an indicator of growth and expansion of business.
- It is always about balance. Therefore, a very high Net Working Capital might indicate excess inventories, which are not considered healthy for a business.
How to calculate additional working capital?
The Working Capital ratio determines where the business stands in terms of the capability of meeting its current expenses and also funding the upcoming expenses.
Working Capital can be calculated from the following formula:
- WC (Working Capital) =Current Assets/ Current liabilities
- The Net Working Capital or NWC shows the readily available money to meet daily operations or expenses.
- The Net Working Capital of a business can be derived using the following formula:
- NWC (net Working Capital) = Current assets - Current Liabilities
Here, the assets considered to calculate the NWC are short-term assets of the business like cash in hand. In short, the money that a business' customers owe, the inventory that is convertible within a year, or the cash itself, makes the current assets of a company.
Similarly, only short-term liability shall be considered while deriving the working capital. Example: accrued salary, accounts payables, taxes, etc.
Every business should try to maintain a good working capital ratio in order to ensure growth and expansion, which in turn, also uplifts the business standing in the industry.
When is additional working capital needed?
Almost every business faces seasonal differences in the returns and cash inflows. There are times when a business might not do so well on the cash and profits. Therefore, it might be ready with the extra capital to ensure the smooth functioning of the operations even in times of less inflow of cash. In such situations, additional working capital is needed.
Another situation that might lead to the need for additional working capital is the gap between the obligations and the due dates of the expected payments. In simpler terms, a business often finds itself in a place where it cannot wait for the expected payments to meet the supplier's obligations, therefore, in such cases; the additional working capital can be used to meet such urgent expenses in the business.
To ace in the industry sometimes it becomes important to always stay ahead of others. Therefore, having an additional working capital always helps the business in investing in more resources, availing big discounts while purchasing in bulk, and taking many more small steps to excel in the competitive market.
Additional working capital also helps in meeting the demands of their employees such as advance payment of salary. This helps a business to instill trust and security in the employees.
Types of Working Capital
Working capital can be categorized as follows:
Based on the concept:
Gross Working Capital: The total current assets is considered as the Gross Working Capital
Net Working capital: The difference between the current assets and liabilities is known as NWC.
Based on Time:
Permanent Working Capital: When the life of the working capital is one year with a part of the investment being permanent. It is known as Permanent Working Capital.
Temporary Working Capital: Temporary or Circulating Working Capital keeps on fluctuating with time and is not permanently invested.
What is the working capital definition?
Working capital can be defined as the difference between the current assets and liabilities.
What are the factors that affect the working capital?
The factors affecting the working capital are: Nature of the busses, changes in technology, seasonal or cyclic changes, length of the production cycle, availability of credit, paying habits of the customers, and the estimated growth and expansion of a business.
How does the nature of business affect the need for working capital?
A big scale business needs more working capital as compared to small scale business.
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