Your One-Stop Guide to know all about Working Capital

Working capital is important for any business because it is interlinked with day to day operations. It depends on the state of your working capital that whether or not you will be able to handle an upcoming project.

For example, if you have been unable to pay your employees on time, then it is not a good sign for your working capital. In other words, you are near a financial backdrop which might be beyond your expertise to handle.

Having the capacity to turn your business upside down, working capital could be quite a challenge if you lack in-depth knowledge about it.

So let’s drill down the essentials of this important business attribute:

1. Types of working capital

Working capital is not one dimensional. It can take multiple forms and types. Let’s explore them in the following section:

I. Gross working capital: In layman's terms, the current assets of a company are what we dub as gross working capital. Managing gross working capital could be a little tough due to the element of unpredictability because sometimes it is tricky to evaluate the exact time of the conversion of your current assets.

II. Net working capital: The difference shown on a balance sheet between current assets and current liabilities is called net working capital. In other words, these assets have the financial backing of long-term assets and therefore are considered more efficient in managing working capital.

III. Permanent working capital: It is also known as fixed working capital. By all means, permanent working capital is bound to be invested. The investment could take the form of account receivables, cash or stocks. The day to day existence of your business is dependent on this type of capital.

IV. Variable/temporary working capital: Once you have a grasp over the concept of permanent working capital, you can easily comprehend variable working capital. As the formula goes; it’s the difference between net working capital and permanent working capital. since fluctuation is part of variable working capital, it makes its forecasting quite a difficult task.

2. Calculating working capital

How to calculate working capital is a common question. Well, its very easy; you have to subtract current liabilities from current assets. Current assets are typically what you can liquidate within a year. These assets include inventory, account receivable, and short term investment.

On the other hand, current liabilities refer to debts and accounts you have to pay in a year. Payroll expenses, wages, sales tax, overdrafts, etc are all forms of current liabilities.

So the equation is very simple; your current assets must surpass your current liabilities in order to maintain positive working capital.

It is pertinent to mention here that you should keep calculating the change in working capital so that you can know how much you have progressed or declined from a particular point. To calculate the change in working capital, you need to apply the following formula:

(current net working capital) minus (previous net working capital)

Rest assured, this practice will always keep you on track.

3. Working Capital Ratio

The working capital ratio is another tool to measure the health of your business. Its formula goes; current liabilities divided by current assets. The numbers of working capital ratio give you a clear picture of where your business presently stands.

For example, the ratio of 1 suggests that the company is going through negative working capital. Anything above 2 means the company is falling short of investment and has too much money engaged in debtors and inventory. The ideal ratio would be between 1.2 to 2.

You should build the habit of assessing the ratio on a frequent basis because a declining ratio can soon wreak havoc on your business. It can only be controlled through immediate attention.

4. Approaches to Working Capital

There are three standout strategies to get on with working capital. Naturally, all of them are totally risk-free. Depending on your style of doing business, you can opt for the one which works best for you:

I. The aggressive approach: This strategy involves the maximum risk and hence maximum output in terms of profit. The aggressive approach takes your entire variable working capital and some portion of permanent working capital. Now you can imagine the element of risk goes with this method.

II. Conservative approach: Needless to say, it stands in total contrast to the aggressive approach. In other words, we know such type of mentality as “playing safe”. Meaning, minimum risk and minimum profit. The conservative approach also saves you from interest rate fluctuations.

III. The moderate approach: This approach comes up with the balance. It has a bit of both – conservativeness and aggressiveness. This strategy is based upon the rule of utilizing long-term resources to finance long-term assets.

5. Maintaining a Healthy Working Capital Cycle

You should take the following measures to ensure the stability of your working capital cycle:

I. Supply of raw material: Raw material is what kickstarts most of the businesses. By any mean, you should have an adequate supply of raw material to keep up with the production. This is the first step towards a secure working capital cycle.

II. Selling: Once the products are ready, you should endeavor to sell them at the earliest.

III. Timely payments: Timely payments are very important to keep the cash flow going smoothly. Delay in the collection is usually the tipping point for the rest of the problems related to the working capital cycle. Many businesses today have introduced discounts for customers who don’t prolong their payments.

IV. Liquidity: Liquidity needs to be given some space as well otherwise your working capital cycle is bound to suffer. Long terms assets like office building can be considered for liquidity to obtain a better cashflow.

V. Refinancing debt: It can be a productive option under suitable circumstances. If you have a clean record of making payments on time, you can consider this alternative.

VI. Cut expenses: Small expenses account for a significant sum which affects your working capital in the long term. For a big corporation, it is laborious to first trace and then strip off small expenses but it does help.

6. Benefits of a Satisfactory Working Capital

Working capital needs to be given a lot of attention because it has a lot to offer your business. Here is a brief list of its perks and privileges:

• Managing working capital helps you to maintain a good credit history. In case your organization falls upon tough times and in a dire need of financing, good credit history will support you to get the loan easily

• You can hire new recruits and train them before your business picks up the pace

• You will think beyond debts and daily operations and take necessary steps to grow your business in the long term basis

• It also results in higher productivity. When employees are paid on time, they go the extra mile to give their best.

The explanation sheds light on the importance of working capital. Salaries, expenses, growth and almost everything you can name about a business, they all come down to the single component known as working capital. you can’t ignore this until you want your business to come to a standstill.