What is Working Capital – Definition and Components Explained

What Is Working Capital

‘Working Capital’ is the term used basically to indicate the financial condition of a firm or an organization in the short term. In other words, it can be called a scale to measure the overall efficiency of the business entity.

To obtain the working capital of a specific firm or organization one is required to subtract the current liabilities from the total current assets of the entity. This ratio suggests whether the particular organization has sufficient assets with it to take care of its short-term debt. To put it the other way, working capital is an indicator of the liquidity levels of an organization for taking care of day-to-day expenditure and cash, accounts payable, inventory, accounts receivable, and also due short-term debt.

Working capital is obtained from many company operations like inventory and debt management, revenue collection, and supplier payments. Now with the concept of working capital being clear, one needs to know about different types of working capital and the various sources from which it can be derived for the company or the firm.

Sources of Working Capital

The sources, from where working capital can be derived, can be classified under three categories – short-term, long-term, or spontaneous. Short-term capital comes from tax provisions or dividends, public deposits, cash credit, short-term loans, trade deposits, inter-corporate loans, commercial paper, and also bill discounting. Under the category long-term, working capital falls long term loans, retained profits, provisions for depreciation, share capital and debentures, etc. On the other hand, spontaneous working capital is mainly obtained from trade credit which includes bills payable and notes payable. So these are the three types of working capital of a business entity based on their needs.

Also Read: Types of Working Capital

The cycle of Working Capital

The WCC or the Working Capital Cycle is defined as the span of time which is required for converting the current net liabilities and also needs to convert the different assets into some cash by any company. It acts as an indicator that can be used to determine organizational efficiency for effectively managing the liquidity position for the short-term and also the cycle, which is calculated using days. It is actually the time span that lies in between the revenue generation using cash by selling products and material buying for producing various products.

The shorter will be the working capital cycle, the faster the company would free up the cash that is blocked. If the working cycle is much longer, the capital would get stuck in between without getting the returns for this operational cycle. Such businesses are always striving to lower the working capital cycle for viewing towards enhancing this liquidity for the short-term.

The formula of Working Capital

The working capital formula is as follows:

Working Capital is equal to current assets minus current liabilities

The ratio of the working capital indicates whether there are ample short-term assets that have the organization that is necessary for managing the short-term debt. A ratio that is lower than one indicates negative working capital whereas sufficient or positive working capital is generally indicated by a ratio which is between 1.2 and 2.0. A ratio above two generally indicates there are some extra assets that are not currently invested by the organization and would represent a missed opportunity.

The company might be in some trouble if these current assets are not exceeding the liabilities at that moment. Working capital is also necessary for the efficiency of the company. Money that is stuck in the market, a bigger inventory, or goods are given to customers that have not been paid by them, would not be even considered useful when it would come to settling some obligations.

Working Capital Benefits

There are working capital loans offered that have the following benefits:

• No collateral is required
• Loans start from Rs 50,000 to Rs 2 Crore.
• Loan tenure is quite flexible as it can range from 1 month to 36 months
• The interest rate Starting from 1.25% per month as per the credit profile
• Quick online application & also the approval process
• It requires minimal documentation- with only KYC documents, passport-size photos, business vintage, and some financial documents required.
• It also has easy-to-meet eligibility criteria for business owners and SMEs.

The Benefit of Working Capital on any Business

Working capital is an essential component of the business that doesn’t depend on the size and scale of operation. The benefits of the working capital include –

• It allows a smooth production flow
• Helps in boosting the liquidity
• Also ensures proper use of the fixed assets
• It aids a project in getting a positive image of the firm
• Also enables the firms for availing benefits for the cash discounts
• Aids in availing financial assistance such as loans easily
• It also allows meeting the contingencies very effectively

Things You Must Know About The Components Of Working Capital

Some of the components which you must know about working capital:-

1. Inventory

Inventory is a very important component of the company’s current assets, which is a result of the essential for the proper management of the working capital. Generally, the semi-finished raw materials, and also finished goods create the stock or inventory.

2.Accounts Receivable

The trade receivables or accounts receivables are the unpaid bills that a company starts while selling and/or delivering the goods on some credit.

3. Accounts Payable

The trade payables or accounts payable are an important part of the current liabilities. Additionally, the accounts payable notify this amount which a firm needs to pay against the credit purchases that have been made. Experts also recommend that businesses adopt some well-rounded management strategies to ensure timely payments for a smooth cash flow.

4. Cash And Cash Equivalent

This is one of the most essential components undoubtedly for the working capital is the current assets, as this helps in maintaining and optimizing the operation activities. It must be noted that this also needs to include some liquid securities which need to be easily converted. It is essential for managing the cash very efficiently for optimizing the operating cycle, cutting unwanted expenses, and boosting profitability.

Also Read: Accounts Receivable Financing

Examples Of Working Capital Affecting The Company’s Cash Flow

This is a fact that various sections of the financial statement of the company tend to influence in one way or another. Some of the best examples of such an impact on the change in working capital on the cash flow are mentioned below.

For example, such an increase in the firm’s current liabilities and current assets by some of the same units would not lead to any change in the working capital.

Some of the examples below offer an idea about this impact –

• When a company sells its fixed asset, this increases the cash flow which in turn, would boost the working capital.
• If the firm decides to replenish the inventory, the working capital would not show any change. This is because both stock and cash are considered current assets. But, these inventory purchases would lower their cash flow.
• Purchasing their fixed assets would decrease the firm’s flow of cash, which would in turn lower the current assets.

Since the working capital and cash flow are closely knit it is necessary for adopting their flow of cash management strategies and also practicing working capital management. This would lead the firms to optimize themselves and maintain themselves successfully.

Frequently Asked Questions

Are working capital loans unsecured loans?

Yes, working capital loans are unsecured loans.

What are the three sources of working capital?

The three sources of working are short term, long term and spontaneous.

State examples of short term working capital.

Short term capital which comes from tax provisions or dividends, public deposits, cash credit, short term loans, trade deposits, inter corporate loans, commercial paper and also bill discounting are examples of short term capital.

State examples of long term working capital.

Long term working capital falls on long term loans, retained profits, provisions for depreciation, share capital and debentures, etc.

State examples of spontaneous working capital.

Spontaneous working capital is mainly obtained from trade credit that includes bills payable and notes payable.

What is the ideal ratio for working capital?

A ratio between 1.2 and 2.0 is the ideal ratio.

What are the parts of working capital?

The parts of working capital are inventory, accounts receivable, accounts payable and cash & cash equivalent.

Are cash flow and working capital related?

Yes, they are very closely related.

If a company sells off their fixed assets what happens to the working capital?

The working capital gets boosted if a company sells off their fixed assets.

What leads to lower current assets?

If a company purchases the fixed assets it would lead to lower current assets.

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