Working capital indicates the liquidity levels of businesses for managing day-to-day expenses and covers inventory, cash, accounts payable, accounts receivable, and short-term debt. It is an indicator of the short-term financial position of an organisation and is also a measure of its overall efficiency.
Working capital = current assets - current liabilities
This calculation indicates whether the company possesses sufficient assets to cover its short-term financial needs.
Sources of working capital
The sources for working capital can be long-term, short-term, or spontaneous. Long-term working capital sources include long-term loans, provision for depreciation, retained profits, debentures, and share capital. Short-term working capital sources include dividend or tax provisions, cash credit, public deposits, and others. Spontaneous working capital comes from trade credit, including notes payable and bills payable.
Types of working capital
There are several types of working capital based on the balance sheet or operating cycle view. A balance sheet view classifies working capital into two types of working capital:
- Net (current liabilities subtracted from current assets featuring in the balance sheet)
- Gross working capital (current assets in the balance sheet)
The operating cycle view classifies working capital into temporary (difference between net working capital and permanent working capital) and permanent (fixed assets) working capital.
Working capital cycle
Working capital cycle refers to the time taken to convert net current liabilities and assets into cash by a business. The shorter the working capital cycle, the swifter the company will free up its blocked cash. Businesses strive to lower this working capital cycle to enhance liquidity in the short term. Bajaj Finserv offers working capital loans to address any deficits in working capital and ensure optimal operations.
Components of working capital
The components of working capital include current assets (such as cash, inventory, accounts receivable), and current liabilities (such as accounts payable, short-term loans, accrued expenses). The current assets are used to finance the company’s short-term expenses, while the current liabilities represent the company’s payments that are due within a year. The working capital ratio (current assets divided by current liabilities) is frequently used to assess a company’s liquidity and its ability to meet its short-term obligations.
Current assets are the assets of a company that are expected to be converted into cash or consumed within a year. The most common types of current assets include cash and cash equivalents, accounts receivable, inventory, and short-term investments.
These assets are important because they help the company to fund its daily operations, pay current liabilities, and make necessary investments in the short term. Additionally, a company's ability to manage its current assets efficiently is a critical factor in maintaining its working capital and liquidity.
Current liabilities refer to the company's obligations that are due within one year or the operating cycle, whichever is longer. Common examples of current liabilities include accounts payable, short-term loans, accrued expenses, and taxes payable.
Managing current liabilities is essential because it impacts the company's working capital, cash flow, and overall financial performance. A company with strong current liability management practices can better finance its short-term obligations, achieve profitability, and create long-term financial stability.
Additional Read: Importance of capital budgeting
Advantages of working capital
There are several advantages to having adequate working capital, including:
- Improved cash flow management, which can help a business meet its financial obligations and avoid cash shortages.
- Ability to meet unexpected expenses, such as unexpected repairs or emergency purchases, without risking the financial stability of the company.
- Ability to take advantage of new business opportunities, such as expanding into new markets or investing in research and development.
- Increased market share and competitiveness, as a business that can meet customer demand consistently is more likely to succeed in its industry.
- Increased flexibility and resilience, as a business with adequate working capital can easily weather economic downturns or unexpected events.
What is negative working capital?
Negative working capital occurs when a company's short-term debts are more than their current assets. It means the company's liabilities exceed its ability to pay them, causing financial stress.
This affects businesses significantly, making it difficult for them to pay expenses, such as debts, salaries, or supplier invoices. It also indicates weak cash flow and poor financial management, thereby harming the company's credit score, increasing the risk of bankruptcy, and discouraging investors.
Negative working capital can result from slow-paying customers, excessive inventory, poor cash flow management, or insufficient sales. It may also be a deliberate financial strategy of delaying payments to vendors to conserve capital, which can lead to negative working capital.
Businesses can improve their working capital situation by negotiating payment terms with suppliers, managing inventory levels, facilitating favourable customer collections, and seeking alternative funding methods such as invoice financing or asset-based lending. Regular financial audits also help identify and rectify the underlying causes of negative working capital.
Frequently asked questions
Working capital is calculated by subtracting current liabilities from current assets. The formula is: working capital = current assets - current liabilities.
Working capital life cycle is the process by which a company manages its working capital, from the initial stage of purchasing raw materials and inventory to the final stage of collecting payments from customers.
Working capital represents a company's operational liquidity, measured by current assets minus current liabilities. It reflects a firm's ability to cover day-to-day expenses and short-term obligations, crucial for smooth business operations and growth.
The four types of working capital are:
- Permanent working capital: The minimum amount needed for regular operations.
- Variable working capital: Fluctuating capital to manage seasonal demands.
- Gross working capital: Total current assets available for daily operations.
- Net working capital: The difference between current assets and current liabilities.
Working capital is the financial metric representing a company's ability to meet short-term financial obligations. Its primary purpose is to ensure there's enough liquidity to cover day-to-day operational expenses, manage short-term debts, and support ongoing business activities effectively.
Working capital finance refers to the funds that a company borrows to finance its short-term operational needs, such as paying salaries, purchasing inventory, and other expenses. Working capital loans are typically used to address cash flow challenges or unexpected expenses.
Working capital is known as the capital that a company uses or requires to finance its day-to-day operations. It is made up of the company's current assets (such as cash, inventory, and accounts receivable) and current liabilities (such as accounts payable, short-term loans, and accrued expenses). Working capital is essential for a company to continue its operations, maintain its cash flow, and fund its short-term business needs.