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Working capital is a measure of a company’s financial health and is therefore a crucial aspect for businesses. It refers to the money available for businesses to fulfill their current and short-term expenses. It indicates whether the company has a healthy cash flow to manage its operations. There are different types of working capital that a company maintains to use for specific short-term needs.
What is working capital?
Working capital is the difference between current assets and current liabilities of a business. It measures the company’s liquidity and gives an insight into its operational efficiency. The formula for calculating working capital is as follows:
Working capital = Current assets – Current liabilities
Components of working capital
As mentioned in the formula, the components of working capital include current assets and current liabilities. Let us have a look at some components of current assets and current liabilities.
- Account receivables
- Cash and cash equivalents
- Account payables
- Wages payable
- Loan payment
- Tax payable
Example of working capital
Have a look at the current assets and current liabilities of Company X:
Accounts receivable – Rs 6,00,000
Cash and cash equivalents – Rs 24,000
Inventory – Rs 1,20,000
Total current assets – Rs 7,44,000
Accounts payable – Rs 35,000
Wages payable – Rs 1,00,000
Loan EMI – Rs 45,000
Total current liabilities = Rs 1,80,000
Working capital of Company X = Rs 7,44,000 – Rs 1,80,000 = Rs 4,64,000
Maintaining a healthy working capital is crucial for businesses to run their daily operations. However, there are times when businesses are unable to maintain working capital balance. To address this challenge, banks, NBFCs and other lending institutions provide working capital loans for short terms (usually 1 year).
Types of working capital
There are various types of working capital that help satisfy a company’s short-term needs. Given below are the types of working capital:
- Gross and net working capital
These two types can be seen on the balance sheet of every company. Gross working capital is the total of all the current assets before considering any short-term liabilities. Net working capital is the difference between current assets and current liabilities.
- Fixed working capital
Fixed and temporary working capital is the sum of money reserved for paying off current liabilities including daily operational expenses. Fixed working capital is the amount of financial resources the company holds in its accounts to fund its operations without any interruptions. This is the minimum sum of money that the company reserves to pay its short-term liabilities.
- Regular working capital
Regular working capital is one of the types of working capital in financial management that helps the company handle its daily operational expenditure. Salary payments, raw material purchases, operational overheads, etc., are the expenses paid with the help of regular working capital.
- Seasonal working capital
This is the working capital that a company puts away for managing peak season when products of a company have a seasonal demand.
- Special working capital
Working capital reserved for unexpected expenditures is called special working capital. If a machine breaks down or if there is an accident on the factory floor, companies make use of special working capital.
In specific cases, lenders offer loans to address such needs. E.g., machinery loans to address the need to buy equipment.
What is working capital management and why is it important?
Working capital management is how a company ensures that it has a healthy cashflow to maintain its daily and short-term operations without interruptions. This helps the companies to improve cash flow management and earnings quality by using their resources more efficiently.
Working capital management tries to minimise the expenses while maximising the return on asset investments. Types of working capital management include inventory management and management of accounts receivable and accounts payable.
Here are a few benefits of working capital management:
- Increases profits
- Improves operational efficiency
- Improves liquidity
- Ensures a healthy cashflow
- Improves earnings
- Minimises the cost of capital spent on the working capital
- Maximises the return on current asset investments
Working capital ratio
The working capital ratio or the current ratio is calculated by dividing a company’s current assets by its current liabilities. This is a measure of a company’s liquidity and short-term financial health. The faster the current assets can be turned into liquid cash, the faster the company can pay off its debts and creditors. Therefore, it is important to know when the individual current assets can be turned into liquid cash and when the current liabilities will need to be paid.
Have a look at an example for the calculation of current ratio:
Current assets = ₹2,90,000
Current liabilities = ₹1,00,000
Working capital ratio = 2.9
The current ratio allows for a comparison between companies of different sizes. However, knowing a company’s current ratio and its amount of working capital is still not enough. It is also important to know when the individual current assets will be turning to cash and when the current liabilities will need to be paid.
How can a company improve working capital?
A healthy working capital indicates the cash flow of a business. A company can improve its working capital by increasing its current assets. Here are a few methods companies can employ to increase its working capital:
- Collect cash from your creditors on time and collect penalties for late payments
- Issue invoices faster
- Delay payments to suppliers by negotiating longer payment period
- Improve inventory management and avoid overstocking
- Reduce the debt of your company
- Lease your assets for making extra income
- Outsource operations that require large investments like marketing, advertising, etc.
- Utilise tax incentives granted by the government and save this cash in the reserve account
- Take a working capital loan for unforeseen circumstances like supply chain disruptions
How can working capital loans boost business growth?
Working capital loans are taken to satisfy a business’s short-term financial obligations and help with the daily cash flow. Expenses such as payroll, rent, and debt payments are paid up with the help of different types of working capital finance. Business entities with high seasonality or cyclical sales usually apply for working capital loans to fund periods of reduced business activity.
Types of bank credit for working capital include invoice financing, term loans, short-term loans, etc. Business credit cards issued by banks can also help you make purchases on credit. These loans can be of help when companies face delayed payments from clients, supply chain disruptions, low sales turnover, etc.
Banks, NBFCs, online lending platforms, etc., feature working capital loan products for businesses. Platforms like Tata nexarc’s Business Loans offer collateral-free loans up to ₹30 lakhs that can be used to meet the working capital needs of small businesses. A subscription to the platform can help you get a loan offer within 5 minutes coupled with hassle-free loan application process from reputed lenders of India.