Meaning of Working Capital
Working capital refers to capital needed for financing the day-to-day operations of a business organization. It reflects the number of funds which is needed by the business for meeting its regular operations. Working capital determines the liquidity position of a company as well as acts as an indicator of business efficiency. It is also termed as net working capital (NWC), which is the excess of current assets over current liabilities. Current assets are all such assets that can be easily converted into cash within the period of one year. On the other hand, all such liabilities which need to be met within the accounting period are called current liabilities.
The proper amount of working capital is necessarily needed by the business for continuing its operation in an uninterrupted manner. A company is said to be ideal when it has a positive working capital, where it can fund its present operations as well as invest in future growth opportunities. Whereas, negative working denotes that the company’s ratio of current assets to current liabilities is below 1.
Types of Working Capital
The concept of working capital is categorized on two bases: a). On the basis of Value b). On the basis of Time
On the Basis of Value
Working capital is of two types on the basis of value which are as discussed below: –
- Gross working capital- Gross working capital reflects the overall value of current assets held by company. It is the total amount of funds which company has invested in current assets. This working capital does not show the real picture of company’s financial health as current liabilities are not included in it. Various elements included here are account receivable, cash, marketable securities and short-term investments. However, gross working capital on its own is not of much use as it does not give a true picture of financial position of business.
- Net working capital- A net working capital implies the excess of current assets over the current liabilities of business enterprise. It is simply the difference in between the gross working capital (i.e., current assets) and current liabilities. Positive net working capital shows that company is in good position to meet its current obligations. On the other hand, a negative net working capital denotes the incapable position of business to full its short-term obligations.
Both, gross working capital and net working capital differ from one another to large extent. The key difference between the two is that gross working capital is always quantitative and positive in value. However, networking capital is always qualitative and can be either positive or negative in value.
On the Basis of Time
Working capital is of 2 types on a time basis which are as follows: –
- Permanent Working Capital- Permanent amount of working capital is the minimum amount of working capital which need to be maintained by business at every point of time for ensuring its continuity. It is a capital which need to be held without any interruption and regardless of business operation level. It is also called as fixed or hardcore working capital. This is so called because the need for permanent working capital is fixed and not dependent on any of the factors.
The permanent working capital remains constant throughout the operations of business. It enables company is meeting its basis financial requirements like repaying the creditors, paying salaries and rent etc. However, the amount of permanent working capital that need to be maintained varies as per the size and scale of operations.
- Temporary Working Capital- Temporary working capital is a capital needed in addition to permanent working capital for meeting out the seasonal and temporary needs by business enterprise. It is also referred to as seasonal, variable or fluctuating working capital as its need is dependent upon several factors which keeps on fluctuating from time to time. It varies largely with the production volume of business as both sales and production level fluctuate a lot throughout the year. Temporary working capital is generally financed using the short-term funds.
Temporary working capital is further classified into seasonal capital and special variable working capital. Seasonal capital is capital which business needs during peak hours for meeting the additional demand. Whereas, special variable working is one needed for meeting financial obligations of exceptional nature such as advertising campaigns for expanding market area.
Working Capital Cycle
Working capital cycle refers to the time which a business takes to convert its net current assets and current liabilities into cash. It is also termed as the operating cycle of business which reflects its efficiency for managing the short-term position of liquidity. It is the time that an organization takes between the purchase of raw materials for product manufacturing and generating cash via selling these products. A shorter working capital cycle is considered more ideal for business as it means that cash stuck in working capital is freed faster. If the working capital cycle of the firm is longer then its capital gets stuck in an operational cycle without giving any returns.
A working capital cycle varies from business to business and varies as per distinct factors like production process and policies, size and nature of business, credit policy, sales and purchase term and conditions, trade cycle fluctuations, and many more. The focus of the working capital cycle is on 4 key elements of a business enterprise which are cash, debtors, creditors, and stock. In order to maintain an efficient working capital cycle, a business needs to compulsorily exercise control over these factors.
Importance of Working Capital
The importance of working capital to business can be well-understood from the points given below: –
- Strengthen the solvency- Working capital plays an effective role in strengthening the solvency position of business organization. Firms are able to carry out their operations smoothly without any financial problems. Availability of adequate amount of working capital helps business in paying off the short-term liabilities timely thereby leading to uninterrupted flow of production.
- Smooth flow of production- Proper working capital is much needed by firm in order to maintain a smooth flow of production. It enables firm in paying off trade supplier, hiring labor and paying their wages, and also meeting out other operating expenses.
- Proper use of fixed assets- A firm is able to use their fixed assets more efficiently when it has an adequate amount of working capital. In case if there is a shortage of working capital, the fixed assets may remain idle. Also, the interest on borrowed capital and depreciation of fixed assets will need to be incurred unnecessarily.
- Improves goodwill- A firm is easily able to build a good reputation in presence of sufficient working capital. Availability of right amount of fund enables business in making prompt payment of outstanding bills. When all of the operating expenses and current liabilities are paid on time, goodwill gets enhanced.
- Easiness in obtaining loan- Business with adequate working capital enjoys a high solvency and good credit-worthiness in market. This way it become quite easier for firm to obtain additional loans at favorable terms from banks and financial institutions.
- Meeting of contingencies- It supports business enterprise in meeting the unforeseen contingencies. These contingencies are like financial crisis arising out of huge losses, phase of business depression etc., which can be easily overcome with right amount of working capital.
- Timely payment of dividend- Companies are able to pay dividend timely to their shareholders when they have adequate working capital. This results in strengthening and maintaining a long-term relationship with shareholders.