Before going in the discussion of the Concept of Working capital we must introduce working capital. it refers to the amount which you have invested in current assets. It also is known as the soul of any business. Working capital is circulated in the business like blood in the human body. All the financial transaction related to the liabilities or assets can only be completed if you have a sufficient amount of working Capital.
The concept of Working Capital
Working Capital which is also known as with short-term WC is a difference between the current asset and the current liabilities. Its basic calculation can be done on the basis of its Gross current Asset. Working capital term is associated with the source of financing from short term assets or short term source of financing.
What is the definition of working capital?
In simple word we can describe the Working Capital like as “Working capital is the amount of a Firm’s current assets excluding the amount of its current liabilities”.
Working capital is the part of total capital invested by the company in the business organization. In daily routine of business life WC refers to the amount that needed to operate the daily or routine activity of the organization.
If you have the positive working capital in your organization it means that you have sufficient amount of assets or amount to fulfill your daily operational expenses.
What’s included in working capital?
Working capital sources by which you can measure the financial position or liquidation position of the enterprise. Working capital include the following:
What are examples of working capital?
Here is some information from balance sheet of XYZ Company:
Now with the help of working capital formula and the information above from Figure 1, XYZ firm can easily be calculated as under:
$160,000 – $65,000 = $95,000
How can you increase working capital ?
Business organization can be improved or increase working capital with help of following elements:
- Maximizing profitability
- issuing common stock or preferred stock for collection cash.
- replacing short-term debt with long-term Debt.
- long-term assets selling for cash
- settling short-term debts for less than the stated amounts
How to Calculate Working Capital ?
In order to calculate the Working capital Current Ratio can be use. current ration of Working capital can be calculated through current asset divided by current liability. If the ratio is more than 1 it means your current assets are more than the liability.
What is Working capital management ?
Working capital management (WCM) refers to the decision making relating to the short term source of financing and working capital. This includes all the activity regarding the creation of relation in between the short term current assets and short-term liability.
The major goal of WCM is to make it sure that whether the organization or the business have the sufficient amount of working capital or current asset to meet its upcoming operations like short term debts or other routine operations.
IMPORTANCE OF WORKING CAPITAL
Working capital is not the total capital but it is actally a part of total capital which an owner invest in the business. it is also describes as the total current asset excluding total current liabilities of the business.
Working capital is a vital part of a business and can provide the following advantages to a business which increases the importance of Working capital management:
HIGHER RETURN ON CAPITAL
working capital is important for shareholders when they received higher Return on every penny which they invest on the business.
IMPROVED CREDIT PROFILE AND SOLVENCY
Proper working capital management lets the business to pay operate its short term obligations like raw meterial, salaries, payment to suppliers and other operating expenses on time whic helps in imroving the profile of the business and save it from bankruptcy.
according to the latest research better management leads toward the higher profitability ratio. the most important factors are managemtn of payable and account recievable in this regards.
INCREASED BUSINESS VALUE
efficient working capital management enables the business to generate the positive cash flow in the business, the end result of which higher business valuation and enterprise value.
FAVORABLE FINANCING CONDITIONS
if a business has its good relations with its stakeholders and make its all the payment on time the it will be befit for the business good will and also the benefit for favorable in some cases like discount from the suppliers etc.
when a firm make payment on time against Raw material purchase on credit. this will make toward the higher level of procduction and profitability. because when you make payment to your supplier, he will deliver your next order on time which enables your to improve your production level.
ABILITY TO FACE SHOCKS AND PEAK DEMAND
During the period of disaster and tough time efficient working capital management survive the business ramp up the production because of a sudden increase in demand.
Buisness with an efficient source of supply chain can beat the firm or can get competitive edge over other which has inefficient sourcing.
What are the 4 main components of working capital?
Working capital management is the effective and efficient use of all the components of current assets and current liability with the sole purpose to minimize total cost and optimize profit.
There are 4 main components involve in working capital:
Cash is considered as one of the most important components of current assets. All of the important functions and can only be performed with the help of cash. If an organization is better in its cash management, then there is highest chances of success of that business. Cash is required for perform most of teh important business transaction like from acquisition of raw materials to marketing of finished goods. So this is the major responsibility of cash manager to create the balance in between cash inflow and outflow.
This is second most important component of working capital management. it can be defined as the claim from money owed to the firm from customers arising with the sale of goods to its customer. The term receivable also known as sundry debtors.
In simple word we can explain it as, this is the claim on money against the sale of the items to the customer of which payment yet not be collected/ received by the business.
Account receivable is the result of credit sale of the business. And the total volume of this component is depend upon the total credit sale and the credit policy of the business organization. So if the company are capable to collect the amount from its receivables on time, then it will be in position to make payment to the supplier on time. this will make the business able to complete the working capital cycle effectively.
Inventory is the third and major part of working capital. If the business is good in its inventory management it means it has the ability to expand the earning or its shareholders. There are two main objective of efficient inventory management:
- Try to minimization of the inventory in the inventory stock on hand
- Smoothly flow of raw material for the sack of production and for sale.
Accounts Payable Management:
Payables are your creditors or your supplier which also are the most important components of working capital. Payable management is closely related with the cash management. if your manage your payable effectively it means your production will never goes down. when you pay your creditor or supplier on time they will ensure to make your supply chain continuously. This will also a lead toward the improving the business reputation.
Why do we need working capital?
WORKING CAPITAL – WHY YOUR BUSINESS NEEDS IT
Working Capital which is also known as the Operating Asset of the business, is the total amount of asset that the company can liquidate anytime to meet its operational need.
All of the business organization keep the required level of working capital to payoff future payments or meet the current liabilities. With the help of WC one can easily measure the health of the company with respect to the short term or long term.
We need working Capital because of the following points:
- Constrict Business Growth: Better management of WC let the business to the high level of growth.
- Improved Working Capital: there should be balance in working capital. as you create the balance in your working capital the financial position will also improve.
- Complete Daily Operation: Organization need WC because of meeting of there daily operation and other current liabilities.
- Improved productivity: as you have enough working capital you will be in position to payoff you supplier. The end result will be in the form of uninterrupted production and improvement in productivity.
- Increase the profitability: with better planning of working capital organization can increase their profit level.
Working capital cycle
Working Capital Cycle (WCC) is the defined as how much time it takes to convert your current assets and the current liability into cash. As you longer this cycle, the longer a business to finance its required funds to operate its routine activities. There will high chances of survival when you manage your working capital smartly, by collecting from account receivable and payment to the creditors.
If there will be a positive working Capital cycle this will let the business to maintain the balance in its cash inflow and cash outflow.
Working capital cycle Example
You can easily understand the WC cycle with the following example:
A company that purchase raw material from suppliers and pays its suppliers in 30 days but takes longer time up to 60 days to collect the amount from its receivables has a working capital cycle of 30 days. This extra 30-day cycle can be complete by funding from external sources like from bank line or other lending authorities on the higher interest rate. These extra amounts of interest reduces the profitability of the company.
Types of working capital
Types of working capital can be described on the basis of two categories:
- on the basis of the Balance sheet
- on the basis of Operating Cycle
Balance sheet concept of working capital
Balance sheet concept of Working Capital can be categorize into following:
- GROSS WORKING CAPITAL (GWC
- NETWORKING CAPITAL (NWC)
what is the difference between working capital and net working capital?
Gross working capital
Gross working Capital concept describes to the total amount available to Finance the current asset or short term financing of the organization. But remember on the basis of GWC you can’t get the real financial position of the firm. confused..?
I am clearing this thing, because sometimes for financing purpose organization approaches the lending institution to borrow the funds. In this way they increase their current asset or gross working capital, but on the other hand the current liability will also increase. At the end the net working capital will remain the same.
So this concept only shows the increase or decrease trend of the assets of business and also has major advantages to make enable the firm to borrow the fund from Banks or other Financial authorities.
As per this concept:
Gross Working Capital = Total Current Assets
Networking Capital (NWC)
The net working capital concept refer that there is an excess amount of current asset with the firm over the current liabilities. The item which included in current asset are cash in hand, cash at bank balance, stock, debtors, bills amount of receivables. And on the other hand current liabilities has bills payables, creditors under its umbrella. If the amount of excess of current asset over current liability, you can say that company has its strong liquidity position.
One thing that should be clear here is that with every increase of Gross working capital is not mean that there will also increase in the net capital. Increase in Net capital will be make only in situation if there is increase in Gross Working Capital without increase in current liabilities.
Networking Capital simple formula:
Net Working Capital = Current Assets-Current Liabilities
After subtracting current liabilities from current assets the remaining thing will be our net working capital. What is positive and negative working capital?
The following is the Balance Sheet of Bhilwara Textiles Private Ltd. as at 31st December, 2011:
Now, the Gross Working Capital will be:
Net Working Capital will be:
The ratio of current assets to current liabilities will be Rs. 60,000: Rs. 30,000, or say 2:1.
Negative Working Capital And Positive Working Capital
What is positive and negative working capital?
Positive working capital shows the position of the that company has sufficient sources to meet its current liability within given time. and on the other hand Negative Working Capital indicates that business is unable to pay off its short term liabilities.
Therefore analysis forces that there should be balance working capital management. Extra amount of current asset is not favorable for the business.
Is negative working capital Bad?
Yes absolutely, because due to negative WC companies don’t have the sufficient amount of assets in order make the payment to the supplier and other creditors. At the end there in an extension in creditors or account payable which may reduce the profitability of the business.
What does negative working capital days mean?
OR What is ‘Days Working Capital’
Days working capital is the finance or accounting term which refers to the liquidation position of the company. It means how much time or how many days it takes for the business to convert the current asset into the revenue
What is difference between working capital and term loan?
There is difference between Working Capital and term loan. The loan is issued by the lending authorities like banks for the specific period of time and they charge specific amount of interest on this amount. While Working capital loan is the different thing. It is the difference between current asset and current liability.