Types of Working Capital

Are you battling with ongoing losses in your business and unsure about what to do to tackle the situation? Examining your working capital, which significantly affects the everyday functioning of a business, could help you find a solution to your operational challenges. In today’s world, there are different types of working capital you can use to deal with financial challenges and ensure the smooth functioning of your company.

Growing your business is another challenge that working capital can help you with. As a business owner, you must know the optimal amount of short-term capital that you require. This is because a shortage could hamper the growth of your firm, while on the contrary, a surplus increases the cost of production, which in turn raises the price of goods and services.

In many cases, companies face failure and financial losses not because their revenue or profit is insufficient, but due to the unavailability of different types of working capital. Availability of working capital is essential for organisations of any size, from small and medium-sized enterprises (SMEs) to multinational corporations.

There are different kinds of working capital, and all of them immensely affect the liquidity and profitability of a firm. The first step to take when starting a company is to determine and calculate the amount of working capital required in the short term to meet requirements. So, if you are an aspiring business owner, you must know what working capital means, the types of working capital, their importance, and the factors influencing them.

What is working capital?

In simple terms, working capital is the amount required to fund and finance the current assets of a firm, helping it kickstart and maintain daily operations. You can also define working capital as the excess of current assets of the business over current liabilities. Thus, working capital is part of the aggregate capital of an enterprise, and every company requires it to meet short-term requirements.

Businesses with an optimum or required level of working capital are more efficient at managing their day-to-day operations. Moreover, it enables business owners to pay short-term dues and expenses incurred daily. Liquidity, financial soundness, and operational efficiency are the three pillars of working capital. Hence, the formula to calculate different types of working capital is:

Working Capital = Current Assets – Current Liabilities

Current assets: Current assets are those assets of a company that can be easily changed into cash within one year or operating cycle. Examples of such assets include cash, cash equivalents, accounts receivable, inventory, liquid assets, prepaid expenses, and marketable securities.

Current liabilities: Current liabilities are the necessary obligations of an enterprise that the business owner has to pay within a year or one operating cycle. Some examples are notes payable, accrued liabilities, accounts payable, unearned revenues, and the current portion of long-term debt.

Why is working capital crucial for companies?

The most important purpose of having adequate working capital is to fund short-term obligations like the day-to-day expenses of your company, meet urgent requirements, and have sufficient capital as a reserve. Furthermore, you can pay wages to employees, dues to suppliers, taxes, and more. Having short-term capital can also help you expand your company without taking on any debt. If suppose you want to take a loan for expansion, you can easily opt for credit based on your company’s positive working capital.

How many types of working capital are there?

Here are the different types of working capital:

• Temporary working capital
• Permanent working capital
• Gross working capital
• Net working capital
• Negative working capital
• Reserve working capital
• Regular working capital
• Seasonal working capital
• Special working capital
• Variable working capital
• Reserve margin working capital.

Temporary working capital

Temporary working capital refers to the specific amount of capital a company needs for a few months within a year. In India, this type of working capital is usually required during festive seasons mainly because of the immediate increase in market demand. Thus, the need for temporary working capital changes frequently because of the volatile and dynamic nature of business operations and market conditions. In simple terms, this is a type of loan that you take for a short period to meet an immediate obligation, and you can pay it back once the company starts earning cash.

Permanent working capital

Permanent working capital is the portion of capital that permanently remains associated with the current assets so that the firm can run without interruption. It is also known as fixed working capital as it is the minimum amount an enterprise is required to pay for liabilities without converting assets or invoices into cash. The amount of permanent working capital required by a company depends on its size and expansion plans. Moreover, this type of loan is usually required for longer periods.

Gross working capital

Gross working capital is another type of working capital and refers to the accumulated amount of funds you can invest in the current assets of your firm. The formula of gross working capital is the sum of all the current assets of the business. These assets include:

• Cash
• Accounts receivable
• Marketable securities
• Inventory
• Short-term investments.

Gross working capital is not an ideal parameter to judge the financial soundness of a business as it does not reflect its operational efficiency. To understand and lay out a proper outline of the operational soundness and efficiency of your firm, you must compare your current assets with current liabilities. This will show how efficiently your business is using its short-term current assets to meet its daily obligations.

Net working capital

You can calculate this type of working capital as the amount by which your business’s current liabilities fall short of the current assets. The formula of net working capital is the difference between the current assets of the company and the current liabilities:

Net Working Capital = Current Assets – Current Liabilities

In the formula mentioned above, current assets include accounts receivable, the sum of cash, raw material, and finished goods, while current liabilities include accounts payable. The sum of net working capital indicates the operational efficiency, flow of liquidity in the business, and short-term financial health.

In simple terms, firms that have enough working capital have the leverage to grow and expand. On the contrary, those with low working capital have a high chance of going bankrupt.

Negative working capital

This type of working capital refers to a major deficit or shortfall in short-term capital. To put it in simple words, a firm incurs negative working capital when its current liabilities are greater than its current assets. There will be an increase in negative working capital if the current liabilities are constantly rising when compared to the current assets.

While it may sound risky, negative working capital can actually be a strategic move for some firms as it enables them to use funds from suppliers to finance their operations and investments; thus these companies are essentially using working capital as leverage. This can be beneficial in sectors where firms have extended cash conversion cycles. But, negative working capital can also be a sign of financial issues and hence, companies must closely monitor their cash flow and ensure they have enough liquidity to meet their requirements.

Reserve working capital

This is another type of working capital that a company must keep in hand. In an emergency, businesses may need to employ these funds for unforeseen market possibilities or circumstances. Therefore, the term ‘reserve working capital’ refers to short-term finances that firms require to handle uncertainties or prepare for unforeseen situations.

Regular working capital

Regular working capital refers to the minimum amount of capital required by a company to sustain its daily operations. This type of permanent working capital is typically required to support the company’s usual activities and ensure a smooth flow within the working capital cycle.

Regular working capital can help cover monthly wages and salaries, as well as reserve funds for overhead expenses and the procurement of essential raw materials.

Seasonal working capital

This type of working capital refers to the additional capital required by a firm during its peak or busiest period of the year. Businesses that engage in production or manufacturing, or offer services that cater to seasonal demand must maintain their seasonal working capital. It is a type of reserve capital meant to prepare the firm for seasonal variations or unexpected changes in market demand.

You could think of seasonal working capital as a temporary rise in working capital as it is not long-lasting. It is only applicable to companies that have some influence over the seasons, such as umbrella and raincoat manufacturers for whom the monsoon is the pertinent season. The need for working capital will typically rise during the monsoon season due to higher demand and subsequently decline once the heavy rains end.

Special working capital

Depending on the different kinds of working capital required, a company may decide to obtain additional funding as a working capital loan to increase its operational efficiency. It might also require additional operating capital to handle unanticipated events or extraordinary operations. This is special working capital; funds that an enterprise requires in urgent situations.

Companies may require such financing for certain marketing initiatives as well as unanticipated occurrences such as floods and unintentional fires that disrupt operations. Since such occurrences are uncommon, there is no way for companies to forecast these funding requirements.

For instance, the manufacturing of specific medications, surgical masks, and personal protective equipment (PPE) kits increased during the recent Covid-19 pandemic. In this case, pharmaceutical firms would have required additional operating capital to increase their production of medicines.

Variable working capital

This type of working capital falls under the category of temporary investments in a company and is also known as changing working capital. It can shift depending on how large the business is getting or how many assets it has.

Reserve margin working capital

In addition to regular operations, a firm may require capital for unforeseen events. Here, the amount of capital set aside in addition to the standard working capital is the reserve margin working capital. These monies are held in a separate account for unanticipated events such as trade union strikes and natural disasters.

Calculation of working capital

The different types of working capital of a business reflect its short-term liquidity or its capacity to meet short-term expenses. Thus, they symbolise the operational efficiency and financial soundness of a company. As a business owner, you should make sure you calculate the working capital of your firm on a priority basis.

Formula for calculating different types of working capital

While there are numerous ways of calculating the working capital of your enterprise, most businesses calculate it in terms of net working capital. The formula for calculating the net working capital of your firm involves deducting the current liabilities of your company from its existing current assets.

You can convert current assets within one year into cash or cash equivalents as they are liquid. Some common expenses that firms use working capital for include paying debtors, clearing expenses that the owner has to pay in advance or prepaid expenses, depositing cash at the bank, keeping cash in hand, manufacturing goods and raw materials, and storing unsold inventory.

On the contrary, the current liabilities of an enterprise refer to its day-to-day expenses. Examples of these include accounts payable (purchases made from vendors on credit), outstanding expenses, and so on.

While calculating your working capital, you may need to make some adjustments:

1. Take off non-tradable receivables such as loans to employees
2. Minus old, obsolete, and wasted stock from the inventory
3. Deduct declared dividends, buyback shares, and so on from the cash in hand.

Suppose your business has a list of the below-mentioned current assets and liabilities:

Current assets	Amount (INR)	Current liabilities	Amount (INR)
Debtors	INR 1.45 lakhs	Creditors	INR 2.4 lakhs
Unsold inventory	INR 30,000	Outstanding expenses	INR 25,000
Raw materials	INR 10,000
Obsolete stock	INR 4,000
Cash in hand	INR 20,000
Prepaid expenses	INR 1,000
Total	INR 2.10 lakhs	Total	INR 2.65 lakhs

So:

Working Capital = Current Assets – Current Liabilities

Working Capital = INR 2.10 lakhs – INR 2.65 lakhs

Hence, your working capital will be INR 55,000.

If you manage working capital efficiently, your current assets will be more than your current liabilities. A healthy ratio of working capital will fall within a range of 1.2 to 2.

A robust and positive working capital indicates that your firm is effectively covering its day-to-day expenses. On the other hand, if your business has a net working capital of zero, it signifies that you only possess sufficient funds to settle your short-term liabilities. Also, negative net working capital indicates you need to borrow more capital to pay back existing debts.

Factors affecting different types of working capital

• Nature of the business: Working capital requirements vary depending on the type of business. Companies typically fall into one of two categories: manufacturing or trading. The process of turning raw materials into finished products is lengthy and capital is continuously invested in raw materials, semi-finished goods, and final goods storage. As a result, businesses can require additional working capital.
  Contrarily, in the case of a trading business, items are sometimes sold before the actual purchase and sometimes just after the purchase. Here, firms will require lesser working capital. Additionally, since there is no inventory, working capital for such enterprises is practically nonexistent.
• Business cycle: The need for various types of working capital is significantly influenced by the business cycle as well. Companies often expand during the boom phase of the business cycle, necessitating more working capital. They require cash during heightened economic activity to cover the time lag between collection and selling. Additionally, firms require cash to buy more raw materials, which are necessary to make more products and boost sales. To add to this, peak seasons raise the cost of raw materials as well as wages. Therefore, enterprises require additional funds to cover these operational costs.
  
  In contrast, during recessions, there is less demand, which results in a fall in both production and sales of goods. As a result, the business needs less working capital to conduct its daily operations.
• Seasonal fluctuations: Certain industries operate on a seasonal basis, which means that during a specific period of the year, there is a notable surge in demand for their products. In such situations, it is necessary to maintain a larger inventory of raw materials over a specific period. This ensures that products are readily available for purchase when they are needed. Here, businesses will need additional funding to procure stocks, thus increasing their need for working capital.
• Production cycle: This refers to the gap in time between the transformation of raw materials into finished goods, often referred to as the operating cycle. This has a greater impact on a firm’s need for operating cash as well. Longer production cycles mean businesses need more working capital to fund their daily operations. As a result, they may take several steps to shorten their production cycle to lower the amount of working capital they need.
• Operational efficiency: Different types of enterprises have varying operational efficiencies. Companies with higher operational efficiencies will need to invest less money in various types of working capital, while those with lower operational efficiencies will require a greater infusion of funds for working capital.
• Inventory management: Businesses can manage their inventory in several ways. The best way is the one that best serves your company’s requirements while taking into account how long it takes to deliver goods to your customers.
  In contrast to companies that prefer to stock up well in advance, a just-in-time (JIT) programme will require fewer types of working capital because you only need to source the materials when required. JIT policies are advantageous for firms that deal with perishable goods.
  It is generally not advisable for companies to overstock as this ties up a significant portion of their working capital unless there are valid reasons such as cost-saving, tax-saving, and other specific considerations.
• Operating cycle length: The number of days required from material acquisition to customer sales collections is the operating cycle length. Days or months indicate the length of an operating cycle.
  Your firm’s need for different types of working capital is directly proportional to the length of its operational cycle. A longer duration will draw a higher sum and, in general, businesses with a more labour-intensive production process, like car manufacturers, will have a longer operating cycle than those with a less labour-intensive production process, like bakeries. The former will therefore need far more working capital than the latter.
  As a business owner, you will need to establish suitable financial arrangements based on the production lead time required for your products.
• Relationships with suppliers: The forerunners in the supply chain are the suppliers – those a firm purchases goods from or hires to complete services. With these forerunners or suppliers, you can typically bargain for a lower price and better terms and conditions. This element has an inverse relationship with a firm’s need for working capital as the chances of lowering prices or extending credit durations are better the more negotiating power the firm has with its suppliers.
  Consequently, your company’s working capital condition will improve as a result of lower outflows (which will boost net working capital) and an extension of the time you have to pay your suppliers, leading to a shorter and faster operating cycle.
• Credit extension policy: Deferred payment sales are necessary for small firms to protect their operations and create income. Credit policies contain a payback period in which customers have to pay back the debt they owe to your company. A longer payback period will result in a greater need for working capital.
  Small business owners may be more tolerant when it comes to recovering debts from customers since doing so could damage their relationships with such clients as well as the likelihood of future sales. However, while this may appear to be beneficial to the company, such actions might negatively impact the firm’s working capital condition. As a result, all business owners must insist on prompt payments.
• Sales: The amount and types of working capital a firm requires are dependent on several factors, one of which is the number of sales. Your business will have to maintain its current assets to expand its volume of sales. It should eventually achieve the ability to maintain a constant ratio of current assets to annual sales. As a result, the length of the operating cycle and the turnover ratio will decrease, while the current assets turnover ratio will go up. A shorter operating cycle time means less need for working capital and vice versa.

FAQs:

Q.1 What is working capital?

Ans: Working capital is the capital a company has available at hand to meet its short-term requirements and day-to-day expenses. There are different types of working capital available.

Q. 2 Why are the various types of working capital important for businesses?

Ans: Although your firm might be running smoothly, there can be situations where you need money to pay off liabilities immediately. In this case, having working capital at hand is a necessity as it will help you stay on top of such liabilities.

Q. 3 How soon can you get approval on different types of working capital loans?

Ans: The disbursement of different types of working capital loans depends entirely on the loan provider you choose. Usually, loan approval does not take more than 24 hours after submission of the documents when it comes to reputed lenders such as FlexiLoans.

Q. 4 How can FlexiLoans help in financing the day-to-day expenses of my firm?

Ans: The different types of working capital facilities provided by FlexiLoans can help entrepreneurs like yourself with daily operational expenses by providing a loan limit. You have the flexibility to withdraw funds as and when needed within the limits of the loan. This is primarily useful for small and medium enterprises (SMEs).

Q. 5 What are the eligibility criteria to take various types of working capital loans?

Ans: Here are some of the eligibility criteria to avail of different types of working capital loans from an NBFC:

• The business must have an operational history of at least three months
• The business should submit proof of its profits, which have a minimum prescribed level
• The business must submit documents that prove its geographical location.

Q. 6 What are some charges associated with various types of working capital loans?

Ans: There are several charges associated with different types of working capital loans. Some common charges include:

• Interest rate: This can vary depending on factors like the borrower’s creditworthiness, the loan duration, and the type of funding required.
• Processing fees: Some lenders charge a processing fee, which is a one-time fee that covers the administrative costs of processing the loan application.
• Prepayment penalties: Certain lenders may impose charges if the borrower decides to repay the loan before the specified tenure. This penalty helps compensate the lender for the loss of interest income.
• Late payment fees: If the borrower fails to make the loan repayment on time, the lender may charge a late payment fee.

Q. 7 What ratio indicates a healthy working capital?

Ans: A healthy ratio of working capital will fall within a range of 1.2 to 2, which means the business has enough funds to cover its current liabilities and meet its daily expenses.

Q. 8 What are some factors that increase the working capital requirements of a company?

Ans: There are several factors that can increase the working capital requirements of a company. Here are some of them:

• Growth rate: If a firm is experiencing rapid growth, it will likely need more working capital to fund increased production, hire more employees, and expand its operations.
• Industry: Certain sectors such as manufacturing and retail often require higher levels and different types of working capital due to the need to maintain inventory and manage cash flow.
• Sales and payment terms: These can affect a firm’s working capital requirements as long payment terms or delays in receiving payment can increase the need for working capital to bridge the gap between paying suppliers and receiving cash.