What is Working Capital?
Working Capital is a financial metric that demonstrates how much cash and cash equivalent are available with the company at a given period to meet its immediate short-term obligations and fund the growth without incurring additional accrued debt.
Calculating Working Capital is important for modern-day businesses because it helps them identify potential cash flow issues, take corrective measures, plan their future needs, and ensure consistency in meeting short-term business requirements. It is calculated by subtracting the current liabilities from the current assets owned by the business.
Different Types of Working Capital
Before we discuss managing working capital, let us discuss the eight types of working capital.
1. Net Working Capital
Net Working Capital is the difference between short-term assets and short-term liabilities. Calculating net working capital is easy. A higher net working capital indicates the company is in a sound financial position and it can fulfill its debt obligations. In contrast, if calculating net working capital results in a negative figure, it indicates the possibility of the company going bankrupt in the near future.
The formula for calculating Net Working Capital:
Net Working Capital = Current Assets – Current Liabilities
2. Net Working Operating Capital
The Net Working Operating Capital formula demonstrates the company’s short-term financial health. Much like the Working Capital formula, it is calculated by calculating the difference between the Current Assets and Current Liabilities, except cash and cash equivalents. Calculating Net Working Operating Capital enables investors to identify the cash tied to the company’s regular activities, rather than its investments.
The formula for calculating Net Working Operating Capital:
Net Working Operating Capital = Current Operating Assets – Current Operating Liabilities
3. Gross Working Capital
Gross Working Capital is computed by calculating the total value of the company’s current assets. Gross Working Capital includes multiple elements such as accounts receivable, inventory, and marketable securities. The Gross Working Capital doesn’t hold real-world significance because it doesn’t provide visibility into the company’s liquidity.
The formula for calculating Gross Working Capital:
Gross Working Capital = Payments Receivables + Inventory + Short-term Investments + Cash-in-Hand + Marketable Securities + Other Current Assets
4. Permanent Working Capital
Permanent Working Capital is critical to maintaining a company’s day-to-day business operations. It covers various expenditures including employee salaries, rentals, and so on. It is that amount of capital that is locked up in current assets and required to pay any current liabilities.
The formula for calculating Permanent Working Capital:
Permanent Working Capital = Minimum Current Assets – Minimum Current Liabilities
5. Zero Mass Working Capital
Zero Mass Working Capital is the position where the company’s current assets are equal to the current liabilities, and the company has sufficient current liabilities to fund its current assets. Achieving zero working capital benefits the organization with increased investment in the long term through deduction in the working capital.
The formula for calculating Zero Mass Working Capital is the same as Working Capital.
Zero Mass Working Capital = Current Assets – Current Liabilities
6. Negative Working Capital
Negative Working Capital is the position when the company’s current liabilities exceed the current assets. When it happens, the company has inadequate cash, cash equivalents, and assets to pay off its short-term debts, and faces crucial issues in conducting its day-to-day activities.
The formula for calculating Negative Working Capital is the same as Working Capital. However, the business liabilities are higher than its assets.
Negative Working Capital = Current Assets – Current Liabilities
7. Variable Working Capital
Variable Working Capital is also called Fluctuating Working Capital which is primarily used as a disposable investment. Variable Working Capital changes frequently with the changes in the market demand and expansion of the business activities.
The formula for calculating Variable Working Capital is as follows:
Variable Working Capital = Net Working Capital – Permanent Working Capital
8. Fixed Working Capital
The types of working capital also include Fixed Working Capital. It indicates the amount required to fund fixed and permanent assets of the business. The formula for calculating Fixed Working Capital excludes inventory and other sorts of temporary assets, in addition to short-term debts and other temporary liabilities. Unlike Variable Working Capital, Fixed Working Capital does not fluctuate with changes in seasonal demands and business cycles.
The formula for calculating Fixed Working Capital is as follows:
Fixed Working Capital = Total Current Assets – Total Current Liabilities
Components of Working Capital
A. Current Assets
Current Assets are also called Liquid Assets which can be quickly converted to cash within a normal operating cycle. They serve the important purpose of covering the company’s day-to-day expenditures.
1. Cash-In-Hand
Much like households, businesses also need a certain amount in possession to meet their day-to-day expenditures or face emergencies. While some businesses may have three month’s worth of cash in hand, others may have six month’s worth of cash. The actual amount may differ on different factors such as the industry type, and size of the business.
2. Stock Inventory
Stock Inventory is of different types, viz. First, raw Materials which are used for the production of goods. Second, work-in-progress refers to partially assembled goods kept in the production in-house. Third, finished goods which are the assembled goods yet to be sold to the final consumer. Stock inventory is considered one of the most significant assets.
3. Accounts Receivable
Accounts Receivable refers to the money that the customers and other stakeholders owe to the company and are legally obliged to pay for it. In other words, it is the money that the company is expected to receive money from its debtors. Usually, the accounts receivable range from a few days to a year.
4. Prepaid Expenditures
The company makes a prepaid payment for availing discounts or getting continuous access to essential services without interruptions. Most of the prepaid expenditures are typically recurring in nature. Their duration may vary from several months to a year. Examples include telephone charges, rent paid for office premises, leased factory machinery, television advertising costs, and so on.
5. Marketable Securities
Marketable Securities are highly liquid and easily convertible types of financial instruments that enable businesses to raise their capital on public stock exchanges. There are different marketable securities such as stocks, bonds, and mutual funds. They are considered current assets alongside cash, and cash equivalent.
B. Current Liabilities
Current Liabilities refer to the short-term financial obligations that the company is expected to pay within a normal operating cycle. The company may use current assets to settle current liabilities.
1. Accounts Payable
These are short-term financial debts that the company is legally obliged to pay its creditors. For example, a company may obtain goods or services from its supplies on credit. It is obliged to make the payment at the redecided time, otherwise, it risks facing legal consequences. The accounts payable can be from a few months to a year.
2. Unpaid Wages
This includes wages and salaries that are still unpaid. It may include unpaid overtime, bounced paychecks, and final paychecks that are yet to be paid. If an employee is scheduled to work overtime without receiving the overtime rates, this may also be included in the unpaid wages.
3. Debt Portions
This includes the monthly debt payments that the company makes as part of its long-term debt payments. The company is paying back a portion of the money that it has borrowed from the creditors. For example, it may include EMI payments for the heavy machinery that the company acquired a few months ago.
4. Unearned Revenue
Unearned Revenue refers to the money that the company has received from the customers for the products or services that are yet to be delivered. Since the company hasn’t fulfilled the obligation in the contract, it is considered a liability for the business.
5. Government Taxes
Taxes are the financial obligation that companies owe to different Government bodies such as the Central Govt, State Govt, or local bodies like municipalities. Taxes They are of different types such as Direct and Indirect. They are usually paid through the company’s income or savings.
Formula for Calculating Working Capital
Here’s the formula for calculating Working Capital:
Working Capital = Current Assets – Current Liabilities
In the above formula for calculating working capital, we have subtracted the current liabilities from the current assets. It’s easy to calculate the Working Capital for public companies. Their financial statements are publicly available and the data is readily available for anyone.
In contrast, the financial statements of private companies are not readily available. They can only be made available through direct requests, credit rating agencies, or by approaching the Registrar of Companies. The Working Capital is denoted in Indian Rupee (INR).
Examples of Working Capital
Company XYZ has current assets worth Rs. 70,000 and current liabilities amounting to Rs. 30,000. For calculating working capital, we will subtract the current liabilities (Rs. 30,000) from the current assets (Rs. 70,000). Thus, the Working Capital of XYZ is Rs. 40,000. It is regarded as a Positive Working Capital. A positive Working Capital indicates better short-term health and liquidity performance.
In contrast, Company ABC has current assets worth Rs. 40,000 and current liabilities amounting to Rs. 2,40,000. In this case, the Working capital of this company is Rs. -2,00,000. This negative working capital indicates the company’s inability to meet immediate short-term debts.
What are the Benefits of Working Capital?
Now, let us discuss how managing working capital can benefit businesses.
1. Meet Financial Obligations
Maintaining enough working capital allows your company to meet its cash needs for day-to-day business operations. Your company will no longer struggle with cash shortages. It will be in a better position to meet your regular financial obligations.
2. Manage Emergency Expenditures
Much like households, businesses also encounter unusual circumstances and emergency expenditures. A positive working capital ensures you have sufficient liquid capital to pay off emergency expenditures and mitigate operational and financial risks.
3. Gain Competitive Advantage
Businesses must consistently look for new opportunities and stay responsive to new market trends. Working capital plays an important role in helping businesses become agile, and stay ahead of the competitors in terms of innovations and strategies.
4. Better Supplier Relationship
Positive working capital allows you to maintain healthy relations with your suppliers. You will be in a better position to negotiate to keep the lending or procurement costs lower and procure high-quality raw materials.
5. Mitigate Market Risks
A business requires adequate working capital to face financial constraints in times of economic downtimes. Adequate working capital allows your business to lower the risk of financial instability and focus on business activities.
What are Different Ways to Improve Working Capital?
Managing working capital is essential for every business regardless of its size and type. A company can improve its working capital in numerous ways.
- It can take long-term loans for 3-10 years. It will make cash available for immediate payments, but it won’t add up to current liabilities.
- It can take out new long-term loans to finance its existing short-term loans.
- It can use an inventory management system to reduce the instances of overstocking, which ultimately translates into lower inventory storage costs
- It can sell liquid assets such as government bonds, marketable securities, and stocks to add current assets without losing their face value
- It can use a dedicated accounts receivable automation system to identify the customer’s creditworthiness.
- It can cut down its recurring and unnecessary expenditures to reduce the current liabilities
Final Words
Working Capital is a critical financial metric that helps analyze a company’s liquidity level and identify its ability to pay off its short-term debts such as bills, supplier payments, interest payments, employee salaries, and Government taxes. Businesses can leverage the versatile capabilities of ERP Software for better capital management & revenue tracking.
Sage X3 is a future-proof solution that provides a sweeping overview of your business operations, and richly detailed analytical reports to evaluate and improve the business’s liquidity level. Its business-critical modules help your business with effectively managing working capital and facing various financial and operating challenges.
FAQs
1. What is the Definition of Working Capital?
Working Capital meaning the amount of funds available for fulfilling the short-term financial obligations of the company, achieving sustainable targets, and improving the short-term liquidity level. It is an important financial measure that provides insights into the liquidity level of a company.
2. What is the Working Capital Ratio?
The Working Capital Ratio demonstrates the company’s current assets in proportion to the current liabilities, to determine whether its current assets can pay off its current liabilities. Calculating the Working Capital Ratio allows investors to determine the company’s financial health and liquidity position.
3. What Does a Negative Working Capital Ratio Indicate?
A negative working capital ratio indicates that the company’s current liabilities exceed its current assets. A short-term negative ratio is typically considered normal. It indicates a substantial increase in the accounts payable or large cash outlay. However, if it remains negative for longer, it may indicate higher reliance on borrowings and a cause for concern.
4. What Does a Higher Working Capital Ratio Indicate?
A higher Working Capital Ratio is generally a positive indication for the company and its shareholders. It indicates the company’s ability to repay its current liabilities. In other words, the company is in a sound financial position to repay its short-term loans. The higher the working capital ratio, the better.
5. Does Working Capital Always Remain Unchanged?
No, the Working Capital does not remain unchanged all the time. In contrast, it changes from time to time due to various factors which is why managing working capital is essential. For example, fluctuations in the company’s turnover, increased labor and material costs, and large outgoing payments can impact the Working Capital.
