We have heard this term far more than often while running our business. It is something everything throws light upon and how imperative it is to have a sound working capital suitable for your business.
Let us break it down for you – what is working capital and what is working capital requirement?
Working capital is the amount of money needed for day to day operations, to manage inventory and expenses. It is the suitable amount of money that is tied up in your inventory and operation and liquid money kept spare. Working capital is calculated as Current Assets over Current Liabilities.
Finding the right working capital requirement for your firm requires you to know your business thoroughly, your sales cycle, cyclicality of your business and credit transactions.
There are a few factors affecting working capital and some of the determinants of working capital are:
This ought to be first requirement of working capital. Without knowing your saes figure it is near impossible to forecast your working capital requirement. In order to increase sales, which is the prime motive of every firm one needs to have a strong study of the market place they are working in along with a good hold on assets and liquidity.
- Length of Operating Cycle
Operating cycle is the time it takes to convert cash into inventory and inventory back into cycle. In short, it is the period from manufacturing of goods to collection of payments. An operating cycle should neither be too slow or too fast.
- Credit Periods
Allowing credit periods to customers is an important factor in the working capital requirement. Some might offer lenient credit terms while others are too strict with it. While the period differs from firm to firm, is it essential to not have bad debt or creditors who delay payments.
- Nature of business
Understanding what category your business falls into helps in evaluating your working capital needs. An everyday retail company requires more working capital than a manufacturing firm due to difference in quantities to be kept. Having a seasonal business, like exceeding revenues during festivities also plays a major role for working cap.
How much should be kept aside for emergency changes from business to business and is not something that is easy to evaluate and keep track of. However, if you figure out the perfect amount of contingency to keep aside, it helps in accurate working capital requirement calculations.
Types of working capital
Categorically speaking, working capital is usually divided into two sections:
- Gross Working Capital
Gross, like the name suggests is the total amount of funds invested in the various forms of current assets as a whole. It includes cash in hand, cash equivalents, short term securities, debtors, bills receivable, prepaid expenses and inventories. If the management wants to be thoroughly involved in the day to day business, they can give attention to gross working cap to manage cash efficiently.
- Net Working Capital
Net working capital is the different between the current assets and current liabilities or the excess of current assets over current liabilities. Net working cap can be divided into two categories again, such as positives net working cap and negative net working cap. The positive net working capital exists, whenever the current assets exceed current liabilities. The negative net working capital exists whenever the current liabilities exceed the current assets. Current liability means a liability payable within one accounting year in the ordinary course of business.
These were the main categories of working capital, however if you want to further divide your working capital based on time, they can be segregated as:
– Permanent Working Capital
- Regular Working Capital
- Reserve Working Capital
– Temporary Working Capital
- Season Working Capital
- Special Working Capital
Features of Working Capital
- Short Term Overview – Working Capital helps to give an ad hoc image of how the company is doing for the short term and if the assets are being fully utilized.
- Liquidity – Working Capital is usually very liquid, it being one of the key characteristics, helping it to convert to cash anytime.
- Less Risky – Investments in current assets such as working capital comes with less risk for it is just for short term.
- Permanency – Although it is just a kind of short term capital, working capital is needed by a business forever and always.
- Circular Flow of Cash – With working capital, the entire process if a circle of cash, from the conversion of cash to raw material, to final goods and finally back to cash.
Changes in working capital and how it affects your finances
The impact of working capital changes are reflected in the firm’s cash flow statement, specifically the operating cash flow. The operating cash flow section of the cash flow statement details changes in its shorter-term working capital needs. A positive working capital figure (current assets are greater than current liabilities) means a cash inflow for the period measured. In contrast, a negative working capital position means the firm has spent more cash out than it brought in managing its working capital, or commitments, within a year. Analyzing changes in working capital can be important for any business, but is especially important for firms with seasonal or erratic cash flow needs.
Cash flow being an important component of your financial statements, having a positive working capital has an effect on the liquidity which in turns affects your final position. A negative working capital would be seen as bad sign for the company, showing signs either the company does not have enough liquidity to pay for expenses later or deteriorating revenues due to reduction in inventory and reduction in final products.
Before you look to diversify or expand, always look closely to your working capital and structure of cycle. Knowing well about these two broad categories can help you predict your business finances for the near future and save you a lot of trouble.