WHAT IS WORKING CAPITAL? TYPES OF WORKING CAPITAL LOAN
Sep 21, 2018
Working capital is required by all businesses to support daily operations and activities, which include obligations and expenditure, and is a significant component of operational liquidity. In addition to fixed assets, such as a plant and machinery, equipment, and property, working capital is an essential component of operational capital.
To understand working capital better, let us first try to comprehend the phrases working capital shortfall and short-term borrowings. In their financial statements, businesses describe current assets and current liabilities projected to be recognized or resolved during the regular operating cycle, i.e., 12 months after the balance sheet date. That’s the origin of the notion of working capital.
What is Working Capital?
Working capital is the total worth of a company’s assets that may be constantly cycled to fund ongoing operations. Working capital also aids in determining an institution’s liquidity status or how quickly assets transform into cash.
Suppose the present asset value exceeds the current liabilities. In that case, the firm does indeed have a “positive working capital,” and if the opposite is true, the firm is said to have a “negative working capital.” A firm’s positive working capital guarantees adequate money to cover its operational costs and short-term small business loans.
Types of Working Capital
1. Permanent Working Capital
This is another term for fixed working capital. The term “permanent working capital” refers to the bare minimum current assets necessary to keep a firm solvent. The size of fixed working capital is proportional to the magnitude and growth of the business. Most of the time, long-term financial options are used to get fixed working capital.
2. Variable Working Capital
It is simply the amount involved in a company enterprise for a brief period. Additionally, it may be thought of as increased working capital utilized to adjust for production and sales operations variations. In India, variable working capital is sometimes referred to as temporary working capital.
3. Reserve Margin Working Capital
It is additional money necessary to cover unknown future risks. It is also referred to as “cushion working capital” since it assists in mitigating unjustified business-related risks, allowing businesses to continue operating during a crisis.
4. Seasonal Variable Working Capital
A firm needs additional working capital throughout the peak seasons to fulfill client demand. Business owners frequently seek further financial aid in these instances. In India, the working capital arranged in this manner is referred to as seasonal working capital.
6. Regular Working Capital
Permanent working capital is typically necessary for the usual course of business to guarantee the working capital cycle runs smoothly. The term “regular working capital” refers to the smallest amount a firm requires to conduct its daily activities.
7. Special Variable Working Capital
This form of working capital is best defined as the additional working capital required by a firm to address specific conditions. The unique variable working capital can be used for various purposes, like funding the introduction of new goods, financing marketing campaigns, and disaster management.
8. Gross Working Capital
The term “gross working capital” refers to the total value of a business’s current assets (assets convertible to cash within a year or less). Cash, accounts receivable, inventories, short-term investments, and marketable securities all constitute gross working capital.
9. Net Working Capital
It is, without a doubt, a critical source of operating capital. The amount by which a firm’s total assets exceed its current obligations is referred to as net working capital. In simple terms, this is the differential between the entire current assets and current liabilities of a corporation.
Working Capital Life Cycle
The working capital life cycle refers to the time required for a business to convert its total net working capital to cash. Additionally, it reflects an organization’s skill and willingness to handle its short-term liquidity. In other words, it is the period between the acquisition of raw materials and the generation of money through the sale of produced items.
A business can attempt to reduce the length of its working capital cycle in the following ways:
- Reduced credit duration granted to clients, resulting in a shorter average collection duration. Additionally, providing a cash discount might help enhance the debtor’s turnover percentage or average collection time frame, among other things.
- The business might take initiatives to enhance or streamline its production processes and concentrate on alternative sales methods. This will result in a reduction in the time required to convert inventory to sales. The faster earlier stock is cleared, the more favorable the working capital cycle will be.
- Additionally, the working capital cycle can be decreased by improved negotiation with suppliers of raw materials and items necessary for manufacturing to extend the credit duration.
The formula is:
Working capital life cycle = Sum of inventory days + Receivable days – Payable days
A good strategy to abbreviate this life cycle is to improve the business venture’s competency and liquidity in the short term. Generally, this is accomplished by selling merchandise, creating revenue through sales, and progressively repaying current debts.
Components of Working Capital
The major components of the working capital cycle include:
It is a key element of a business’s current assets and, as such, is helpful for successful working capital management. Inventory or stock would consist of raw materials, semi-finished items, and completed things in an ideal world.
– Accounts Receivable
They are also known as trade receivables, which refer to the unpaid invoices that a business incurs when it sells and delivers things on credit.
– Accounts Payable
They are a significant component of current liabilities. Accounts payable, in general, refer to the balance due on credit purchases made by a business. Experts advise organizations to use comprehensive management techniques to ensure on-time payments and a healthy cash flow.
– Cash Equivalents
Without question, one of the most significant components of working capital is current assets since they enable the continuation and optimization of operational activities. One must keep in mind that cash also contains readily convertible liquid securities. Cash management is critical for optimizing the operating cycle, reducing unnecessary spending, and increasing profitability.
Factors Affecting Working Capital
It is vital to maintain a specific level of liquid cash and assets that are readily convertible to liquid cash. Bear in mind that an organization might run out of cash even though it has an adequate number of current assets. This is because it is still unable to convert its assets to cash.
- Working capital is often influenced by the sector to which it belongs, its rivals, its connection with suppliers, and its association with clients.
- If there is still a no-credit policy, borrowing will be prohibited. This enables the business to run efficiently.
- Only if consumers pay on time, the business will have a minor issue sustaining its working capital.
What Are the Benefits of Working Capital to Businesses?
Working capital is a crucial element of all businesses, regardless of their size or scope of operation. Several advantages of working capital are:
- It contributes to the smooth operation of the manufacturing process
- It contributes to the expansion of liquidity
- It assures the most efficient use of fixed assets
- It facilitates the acquisition of financial assistance, such as a loan, and enables more effective management of contingencies.
Working Capital Finance
Maintaining a business’s operations and many services is no simple feat since it requires a steady flow of revenue. At times, it becomes challenging to create sufficient cash flow to continue operations owing to several issues.
In such cases, you may apply for a working capital loan, alternatively referred to as a business loan in India.
Working Capital Loans of Various Types
1. Short-term loans
The short-term business loan has a specified repayment period and interest rate. This is a revolving loan. However, depending on your credit history and relationship with the lender, you can acquire this business loan without collateral.
2. Credit line
This is the most flexible working capital financing. The lender approves a specific amount of money for the borrower to utilize. The borrower must exercise caution not to exceed the monetary limit allowed. Furthermore, the borrower is charged interest on the amount withdrawn, not on the amount granted. This motivates the borrower to deposit the borrowed funds to avoid paying interest.
3. Trade Credit
Potential or current suppliers provide this working capital credit. When you place a large order with a supplier, they may offer you trade credit. However, this loan is only granted after a comprehensive evaluation of your creditworthiness, earnings, and credit history by the provider.
Working capital loans are typically quick and simple to get, allowing business owners to manage immediate financial demands quickly. Lending institutions like FlexiLoans can link working capital loan payments to the firm’s cash flows, avoiding additional strain on the firm during times of low activity.
Working Capital is the amount of money a business has on hand to cover daily operating expenses. This financial statistic provides a clear view of a company’s financial health and stability. Everything works well for the business if current assets surpass current liabilities; but, if the contrary is true, with liabilities above existing assets, it is a solid indicator that changes must be made to avoid additional loss. The more significant gap between what you own and what you owe demonstrates the company’s sound financial state. FlexiLoans provides MSME business loans with affordable business loan interest rates with a completely online process.