Understanding working capital: A definitive guide
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Understanding working capital: A definitive guide

  • Highlights

  • Working capital is the lifeblood of your business

  • Insufficient working capital hampers business growth

  • How to calculate your firm’s working capital needs

  • Business efficiency can be measured with working capital

In the simplest sense, working capital is what helps your business not just exist, but thrive. It is the capital that fuels your company, regardless of its size, indicating that your operations are running on schedule.

Since working capital is absolutely central to your business operations, understanding its ins and outs is extremely essential for good business health.

What is working capital?

Working capital is a measure of your company’s current assets against its current liabilities. The difference between the two is the working capital that you can use to finance your company’s day-to-day expenses, as well as short-term debt that requires immediate attention. It also ensures that your resources are being used in the best way possible.

What is working capital management?

Working capital management involves ensuring that your business has sufficient liquidity to meet its short-term obligations, so that your business doesn’t slow down or worse still, come to a screeching halt. Before you delve into the various ratios that help with working capital management, take a look at what current assets and current liabilities mean.

Current assets: Assets that can be converted into cash in the span of a year are called current assets. Typically, these include prepaid expenses, debtors, inventory, etc.

Current liabilities: These are the short-term debts that your business is likely to incur during the course of operation, such as outstanding expenses (to vendors/suppliers), short-term loans, etc.

Additional Read: 5 Working capital management tips for your manufacturing business

What is working capital used for?

Here are the most common uses of working capital, among the many applications.
- Maintain inventory
- Pay overhead costs
- Pay salaries
- Pay for raw materials
- Train employees
- Finance expansion
- Maintain a cash reserve
- Tackle unexpected expenses

Hence, working capital forms the lifeblood of your business.

How to calculate net working capital?

Net working capital calculation = Current assets – Current liabilities.
So, let’s assume that your firm has the following assets and liabilities:

Current Assets Amount (Rs.) Current Liabilities Amount (Rs.)
Machinery 1,50,000 Creditors 60,000
Debtors 50,000 Unpaid loans 1,00,000
Inventory 75,000
Prepaid expenses 25,000
Total 3,00,000 Total 1,60,000

As a result, your net working capital= Rs.3,00,000 – Rs.1,60,000 = Rs.1,40,000

How to calculate net working capital?

Assuming that you have a 30-day window to repay your supplier and your customer will pay you back within 60 days, you will need money in the interim to clear the amount due to the supplier, as well as to pay for other business expenses such as utilities and salaries. So, how do you know how much working capital your firm needs?

The easiest way to determine working capital requirements is by expressing it as a percentage of revenue. This involves understanding a different way in which you can calculate net working capital.

Net working capital = inventory + accounts receivable – accounts payable

Factoring each element by itself, will help you calculate net working capital.

a. Accounts receivable
Accounts receivable = Credit period x Daily revenue

Assume that you offer customers up to 45 days to repay you, and your annual revenue is Rs.10,00,000. This means your daily revenue will be Rs.10,00,000/365, which comes to Rs.273.97.

As a result, accounts receivable = 45 x 273.97 = Rs.12,328. When expressed as a percentage, accounts receivable amounts to 1.2% (Rs.12,328/Rs.10,00,000 x 100). This means that at any given point, working capital requirement owing to extending credit will amount to 1.2% of total revenue.

b. Inventory
Assuming that you hold stock for a period of 30 days, and your gross profit margin is 45%, here’s how you can calculate inventory.

Inventory = Days you hold inventory for x daily revenue x (1- gross profit margin %) So, inventory= 30 x (10,00,000/365) x (1-45%)

Inventory= 30 x Rs.273.97 x 0.55= Rs.4,520.50

As a percentage, inventory= Rs.4,520.50/Rs.10,00,000 x 100= 0.45%. This means when you hold stock for 30 days, you need 0.45% of your total revenue to finance it.

c. Accounts payable
To calculate accounts payable, use the same formula-
Accounts payable = days to repay creditor x daily revenue x (1-gross profit margin%)

Assuming that you have 25 days to repay creditors,
Accounts payable= 25 x (Rs.10,00,000/365) x (1-45%)
= 25 x Rs.273.97 x 0.55 = Rs.3,767

As a percentage, accounts payable= Rs.3,767/Rs.10,00,000 x 100= 0.37%

Now you can plug-in this data into the working capital requirement formula- inventory + accounts receivable – accounts payable, and your working capital requirement = Rs.4,520.50 + Rs.12,328 – Rs.3,767= Rs.13,076.5.

As a percentage, working capital requirement= 0.45% + 1.2% - 0.37%= 1.28% of the total revenue.

Also know: What the life cycle of working capital is and how to shorten it

How to determine your working capital needs?

You can calculate your firm’s working capital needs by taking into account the following metrics:
- Nature of your business
- Scale at which you operate
- The time it takes for you to convert raw materials/inventory into revenue via sales
- The percentage of your credit sales and the terms that define repayment
- Seasonal differences in demand and supply if you have a seasonal business such as manufacturing raincoats
- Reserve for emergencies

However, as working capital is dynamic in nature, you should calculate it periodically.

Additional read: How much working capital does your business need?

What are the different types of working capital?

There are different types of working capital and different views or approaches that govern them. Take a look at the ones you are most likely to come across and adopt an approach that is suitable for your business.

1. Balance sheet view of working capital
- Gross working capital
Gross working capital is the amount of money you have spent on your company’s current assets.

- Net working capital
As discussed earlier, net working capital is current liabilities subtracted from current assets. Positive net working capital means that your business’ finances are healthy, while a negative working capital means the opposite.

Between the two, net working capital is more widely used as it offers a more precise, holistic view of your company’s financial health.

2. Operating cycle view of working capital
Here, working capital is measured in terms of the time it takes your company to convert its inventory into revenue.

- Permanent or fixed working capital.
This working capital varies from one company to another, as it is calculated taking into account the lowest net working capital level of one financial year. This level is considered to be ‘fixed’ and the amount that you absolutely must invest towards working capital.

- Temporary or variable working capital
The difference between your net working capital and permanent/fixed working capital is the variable working capital. This working capital gives you the flexibility and financial cushioning that you need to meet expenses through the year.

3. Reserve working capital
Also known as cushion working capital, this works as a reserve that you can use to deal with contingencies and to remedy any damage.

4. Special working capital
This is an amount set aside specially to finance a particular activity. For example, to open a second office or to develop a new range of products you can use special working capital.

How to measure business efficiency with working capital?

The following ratios indicate the overall health of your company’s short-term liquidity-

1. Working capital efficiency
You can gauge this by calculating the working capital ratio, i.e. current assets, divided by current liabilities. If the result is less than 1.0, it is an indicator that your company’s finances need attention. If the result is 1.0–2.0, it means that your company is financially sound. But, if it is greater than 2.0, it shows that your company isn’t using its resources to the best of its ability.

As an SME owner, you should always ensure that your business never runs out of working capital

2. Payment collection efficiency
Receivables turnover is a ratio that helps you determine whether or not you are able to collect payments on time, in line with the sales that your company makes and the credit it extends to others. So, the lower the ratio, the better it is for your company. It indicates that you are able to collect the amounts due to you efficiently.

3. Inventory turnover efficiency
The quicker you are able to sell your inventory, the more efficient your business is. So, the stock turnover ratio helps you monitor the time it takes to convert your inventory into cash. The lower the resulting number, the better your company is at clearing or selling off its stock.

With this information on working capital and its management, you will be able to easily ensure that gaps in working capital won’t hold your business back from performing optimally and achieving growth.

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