Understanding working capital: a definitive guide

Working capital is what helps your business 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 central to your business operations, understanding its intricacies is essential for good business health.

What is working capital?

Working capital is a difference between a company’s current assets and liabilities. The difference between the two is the working capital that you can use to finance your company’s day-to-day expenses and 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 work 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 operations, 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 cash reserves
• Tackle unexpected expenses

Working capital is, hence, the lifeblood of your business.

How to calculate net working capital?

Net working capital calculation = Current assets – Current liabilities.

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		1,60,00

Net working capital = Rs. 3,00,000 – Rs. 1,60,000 = Rs. 1,40,000

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 and 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 in each element will help you calculate net working capital.

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. 2739.7.

As a result, accounts receivable = 45 x 2739.7 = Rs. 1,23,286.5. When expressed as a percentage, accounts receivable amounts to 12.3% (Rs. 1,23,286/ Rs. 10,00,000 x 100). This means that at any given point, working capital requirement owing to extending credit will amount to 12.3% of total revenue.

Inventory

Assuming that you hold stock for 30 days and your gross profit margin is 45%, here’s how you can calculate the inventory

Additional Read: Inventory management techniques

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. 2739.7 x 0.55= Rs. 45,205

As a percentage, inventory = Rs. 45,205/Rs. 10,00,000 x 100 = 4.5%. This means when you hold stock for 30 days, you need 4.5% of your total revenue to finance it.

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. 2739.7 x 0.55 = Rs. 37,670

As a percentage, accounts payable= Rs. 37,670/Rs. 10,00,000 x 100 = 3.7%

Now you can enter this data into the working capital requirement formula, that is inventory + accounts receivable – accounts payable, and your working capital requirement will be = Rs. 45,205 + Rs. 1,23,286 – Rs. 37,670 = Rs. 1,30,821.

As a percentage, working capital requirement = 4.5% + 12.3% - 3.7% = 13.1% of the total revenue.

Additional read: Working capital cycle

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
• The scale of your operations
  
• 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, 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 a suitable approach 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 negative working capital means the opposite.

Net working capital is more widely used between the two as it offers a more accurate, holistic view of your company’s financial health.

2. Operating cycle view of working capital

Here, working capital is measured considering the time it takes your company to convert its inventory into revenue.

• Permanent or fixed working capital.
  This working capital is calculated taking into account the lowest net working capital level of one financial year. This level is considered ‘fixed’ and the amount that you 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 needed 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, you can use special working capital to open a second office or develop a new range of products.

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 that is current assets divided by current liabilities. If the result is less than 1.0, it indicates 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 optimally.

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 can 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 can collect your dues efficiently.

3. Inventory turnover efficiency

The quicker you can 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.

Additional Read: Types of Business Loans

Additional read: Capital budgeting

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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