Working Capital: Key Concepts and Calculations

Working capital is the lifeblood of any business, providing the necessary funds to keep operations running smoothly. It represents the difference between a company’s current assets and current liabilities, indicating how much cash is available for daily business operations. Ask any businessman, and they will tell you the importance of working capital, which is like oxygen for a business and helps maintain solvency. Without adequate working capital, a company may struggle to pay its bills, meet payroll obligations, or take advantage of growth opportunities. Thus, managing working capital effectively is crucial to ensure the long-term success and sustainability of any business.

What is Working Capital?

Working capital refers to the funds that a business has available to cover its day-to-day operations, such as paying bills and purchasing inventory. It is calculated as current assets minus current liabilities and is a measure of a company’s short-term financial health. Adequate working capital is important for businesses to ensure they can meet their obligations and continue operating smoothly.

Working Capital also known as Net Working Capital (NWC), Working Capital (WC) is defined as the difference between a company’s current assets and its current liabilities. It is an indicator of a business’s liquidity and short-term financial health and its ability to utilize its assets efficiently.

Importance of Working Capital Management:

When a company’s current assets are more than its current liabilities, it is said to have positive working capital. This means that the company is in a good position in terms of liquidity and financial health. Hence, having a positive WC helps a company maintain its solvency. The various factors which highlight the importance of working capital are as follows:

• Managing liquidity: By getting a clear idea of impending expenses or expenses coming up, the finance department can take stock of their financial position and arrange for the funds accordingly.

• Avoiding out-of-cash position: Inappropriate planning to day-to-day expenses may cause liquidity issues. In such a case, the company may have to postpone or arrange funds from other sources, which negatively reflects the company’s image.

• Helps decision-making: By correctly calculating the requirement of day-to-day funds, a company takes stock of its current fund position. This allows the company to decide the amount and source of funds.

• Adds value to the business: As the management arranges for funds to manage its day-to-day expenses, the finance department can meet all its payment obligations. This sends out a positive message in the market about the company and enhances its value.

• Earn short-term profits: There are situations when a company has excess funds with them. By calculating its working capital requirements, the company can estimate the amount of excess funds. Over and above the working capital requirements, the company may invest extra funds for the short term and earn some profit.

How to calculate working capital?

The gap between a company’s current assets and current liabilities is referred to as working capital. To calculate a company’s working capital, you’ll need to know its current asset balance and its current liability balance

The formula for calculating working capital is:

Current Assets – Current Liabilities = Working Capital

A business with a positive working capital has more assets than it owes. When a company’s working capital calculation is positive, it has more than enough resources to cover its short-term debt. There is residual cash, and if all current assets were liquidated to pay this debt, the company would still be okay. 

If a company’s working capital calculation is negative, it has more short-term debt than it has short-term resources. This indicates poor short-term health and liquidity issues might result in potential problems paying its debt obligations as they become due.

Working Capital Ratio

The working capital ratio shows the ratio between current assets and current liabilities. The formula is calculated by dividing current assets by current liabilities. 

Working capital ratio = current assets / current liabilities

A ratio of more than 1.0  indicates that the company has more cash and other assets available to pay its debts. This is a good indicator of financial health because it shows whether the company can cover its short-term expenses with cash on hand instead of borrowing money from lenders or investors. A ratio of less than 1.0 indicates that a company may have difficulty meeting its short-term obligations.

Main Components of Working Capital

There are two main components of working capital.

1. Current Asset

An asset that can be turned into cash within a year is referred to as a current asset. Current assets include cash, investments, inventory, and accounts receivable. A company’s ability to pay its short-term debts is dependent on its level of current assets.

Current assets are important because they represent the resources that a company has available to generate revenue and profit. Companies need to have adequate current assets to meet their short-term obligations and maintain operations.

If a company does not have enough current assets to cover its short-term obligations, it may need to borrow funds or sell assets to raise cash. This can put the company at a competitive disadvantage and may negatively impact its financial performance.

2. Current Liability

A current liability is a debt that is due to be paid within one year. Current liabilities are important to monitor because they represent the amount of money that a company will need to pay in the short term. This can be a challenge for businesses, as they need to ensure that they have enough cash on hand to meet their obligations.

There are a few different types of current liabilities, including accounts payable, short-term loans, and accrued expenses. Accounts payable are amounts that a company owes to its suppliers for goods or services that have been received. Short-term loans are loans that are due to be paid back within one year.

Example of Working Capital

Suppose XYZ company has current assets of ₹6,00,000 and current liabilities of ₹4,00,000. 

Here,

Current assets of the XYZ company: ₹6,00,000

Current liabilities of the XYZ company: ₹4,00,000

According to the formula of working capital

Working Capital = Current Assets – Current Liabilities

Working Capital= ₹6,00,000 – ₹4,00,000

Working Capital= ₹2,00,000

The Working Capital of the XYZ company is ₹2,00,000.

As we can see here current assets of the XYZ company are more than the current liabilities which means Its assets are more than sufficient to pay off the company’s short-term debts.

Sources of working capital

A company has various sources of working capital such as Spontaneous Sources, Short-term Sources, and Long-term Sources. 

Spontaneous Sources

Spontaneous sources of working capital are those that are generated during normal business operations.

Long-term Sources

 There are a few long-term sources of working capital that companies can utilize. One common source is loans from financial institutions. Companies can also issue bonds to raise capital. Another option is to sell equity in the company, which can provide working capital in the form of cash. Additionally, companies can take out lines of credit from suppliers or other lenders. 

Short-term Sources

 There are a number of ways to finance working capital on a short-term basis. One option is to use credit cards, which can provide quick access to cash when needed. Another option is to use lines of credit from banks or other financial institutions.

The Benefits of Working Capital for Any Business:

Working capital is like oxygen for a business. Just like we need to breathe oxygen, businesses need to have it. Without sufficient amounts, a company cannot meet daily expenses, pay salaries, make supplier payments, and pay raw materials.

• Ensures Smooth Operations: Provides funds for daily expenses like salaries, bills, and inventory.
• Maintains Liquidity: Ensures the company has enough cash to meet short-term obligations.
• Supports Decision-Making: Helps in planning and allocating resources efficiently.
• Enhances Creditworthiness: Signals financial health to creditors and investors, easing loan acquisition.
• Facilitates Growth Opportunities: Offers financial flexibility to seize new business opportunities.
• Improves Supplier and Customer Relationships: Ensures timely payments and maintains adequate stock levels.

Eligibility Criteria for Working Capital Loans

To be eligible for getting working capital loans, the following are the eligibility criteria:

1. The applicant must be between 24 to 70 years of age. The applicant must not be over 70 years at the time of maturity of the loan.
2. The business must have an operational history of more than 3 years.
3. In the case of last year’s annual turnover being more than 1 crore, the financial statements must be audited by a CA.
4. A good credit rating makes it easy to get a loan and helps get a good deal.

Disadvantages of dependence on Working Capital:

While working capital is an essential tool to maintain the liquidity of a business, there are some disadvantages in depending too much on it.

• Takes into account only monetary factors: Working Capital works purely on numbers. It just takes into account monetary factors like the value of debt receivables, the value of finished goods, the value of accounts payables, etc. Factors like recession, employees’ dissatisfaction, government attitude toward the industry, etc., hold no relevance here. All this makes working capital management purely a number game, which may not be accurate always.

• Does not respond to sudden market changes: Working Capital Management is not dynamic in nature. It is mainly based on past data and events and does not acknowledge sudden changes in market conditions. In today’s dynamic business situations, a delay in responding to a specific event may hurt business operations and profitability.

• Based on data solely: At the center of Working Capital Management lies the data. It’s the soul of this cycle. Data include every minute detail of the working capital cycle. For example, in accounts receivables, it would require the date of sale, the credit period, the grace period, a penalty in case of delay or non-payment, etc. Without data, this strategy does not work. Any error or change in this data may disrupt the entire cycle.

• The problem in interpretation: Working capital management works purely on numbers, ratios to be precise. And interpretations of these ratios are very subjective in nature. For example, experts believe that in the case of current assets, a 1:1 ratio is favorable. At the same time, ratios higher than 2:1 are unfavorable. In case, a business has a longer trade receivables cycle than the industry’s average, it would not be able to interpret the ratio accurately.

Supply Chain Financing – The Modern Way Out

Supply Chain Finance, also called Supplier Finance or “Reverse Factoring”, is an easy and simple way to get funds to meet the working capital requirements of a business. It helps a company get quicker payments for their invoices. This method usually involves a third party or lender (usually a bank or financial institution) who finances the business on behalf of the end customer.

Simply speaking, in supply chain finance, suppliers sell their high-ticket invoices to lenders (banks, financial institutions, or NBFCs) at a discounted rate to get short-term credit. This receipt of this money, much before the invoice due date, gives breathing space to the business and helps them fulfill its operating commitments. 

Benefits of Supply Chain Financing Over Working Capital

Every business wants to get paid as soon as possible. This may not be a problem with cash-rich companies, but for most MSMEs, getting a regular fund flow prevents them from getting choked. Given below are some benefits of supply chain financing:

• Manage inventory more efficiently: While focusing only on Working Capital, a business may have to have more inventory as current assets to maintain a positive WC. This may increase their inventory carrying costs. But with supply chain financing, since the business is able to get payments faster, they can afford to have a shorter cycle. So, they can place smaller but more frequent orders as and when required. This helps them manage their inventory and its carrying costs in a better manner.

• Reduce Days Sales Outstanding (DSO) from customers: Working Capital takes into account the credit period, but it does not take into account the time value of money and the cost of opportunities missed if the money is blocked in accounts receivables. Supply chain financing helps a business reduce its DSO and allows a business to rotate that money into the next production cycle or invest in some more profitable venture. 

• Increase Days Payables Outstanding (DPO) from suppliers: Working Capital takes into account the difference between the current assets and current liabilities. Supply Chain financing helps businesses push their accounts payables to a later date, thereby giving them more breathing space. Using this, businesses can pay their suppliers later and enjoy a greater credit period than what the supplier offered. 

• Strengthens buyers-supplier relationships: Supply Chain financing helps both the suppliers and the buyers. While the suppliers get quicker payments, the burden is not passed on to the buyer. Similarly, the buyers get an extended credit period without the supplier having to suffer. This way, both parties can achieve their business objectives efficiently. Both parties are invested in the success of each other. This makes their business relationship more and more strong.

Conclusion

Working capital is significant to keep a business solvent. A positive WC indicates the short-term financial health of a business. A business with a positive WC ratio can meet all its current liabilities and is believed to be financially sound. But at the end of the day, it’s just a ratio analysis.

Supply Chain Financing is a more practical and dynamic approach compared to working capital management. It lets you run your business without any interruptions and also allows you to take advantage of business opportunities that come your way. It is a highly flexible and reliable method of financing for businesses that require continued working capital. So, if you are getting stuck somewhere and need funds for a shorter time, then supply chain financing makes much financial sense. To know more about how supply chain financing can help overcome various business challenges, give us a call. We will be glad to help you.

FAQs Regarding Working Capital

Q.1 What is a simple explanation of working capital?

Ans. Working capital is a company’s subtraction of current assets and its current liabilities. It is used to measure a company’s financial health and is a key indicator of its ability to pay its debts and meet its financial obligations.

Q.2 What is the formula to calculate working capital?

Ans. The working capital formula is a company’s current assets minus its current liabilities. And the numerical representation of the working capital formula = Current Assets – Current Liabilities

Q.3 What is the main concept of working capital?

Ans. The main concept of working capital is that a company should have the necessary cash available for day-to-day operations and short-term loans. 

Q.4 What is the importance of working capital?

Ans.  Working capital is important because it allows businesses to cover their short-term expenses and meet their obligations. It is a good indicator of a company’s financial health and should be managed carefully.