Working capital is one of the most important components of a business. A business cannot function without sufficient working capital. In this article, let’s take a deeper look into the functions of working capital and its types:
Working capital is the lifeline of any business. Whether you are about to start a business or run an established business you will surely know the significance of working capital. Working capital helps the organization function smoothly and carry out its regular operations like payroll payments and paying creditors.
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Working capital refers to the money required to fund day-to-day business operations. It can also be used to pay short-term debt and cover operational expenses.
Working capital becomes all the more important when you are about to expand and scale new heights. For example, if you are above to start a new venture or a large project that will give you good returns upon completion, you need sufficient capital to fund the expenses during this period. Thus you can either sell your assets or get a bank loan to finance the project.
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Explained below are various types of working capital:
This is also referred to as fixed or hardcore working capital. It refers to the base investment amount among all types of current assets that are required at all times to ensure a minimum level of uninterrupted business operations.
This is also referred to as fluctuating or variable working capital. The temporary fluctuations in the networking capital over and above the permanent working capital are known as temporary working capital. Thus temporary working capital and level of production and sales are closely related.
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Gross Working capital is the sum of the company’s current assets. It includes assets like cash, account receivables, inventory, marketable securities, and short-term investments.
Sometimes, a business or a company has a lesser value of its current assets in comparison to its current liabilities. If such type of situation arises when the company is said to operate on negative working capital.
It refers to the short-term financial arrangement made by the business units to meet uncertain changes or to meet uncertainties. This type of capital is used to meet controllable or uncontrollable risks and sustain the business.
Regular working capital is the minimum amount of working capital a business needs to maintain in normal conditions.
The demand for some products rise seasonally and the main cause of this can be seasonal changes or festivities etc. For example, the demand for raincoats and umbrellas rises during monsoon months. In this way, seasonal working capital means the amount of working capital needed to meet the seasonal demands of the product.
Business often conducts special programs and campaigns to market and sell their products. The programs are carried out in various forms like advertisements, sales promotion activity, product development, marketing research activities, launching of new products or expansion of the product market. Thus, special working capital is referred to as the funds required to meet the expenses if special programs of the business.
Working capital is calculated using a simple formula. All you have to do is subtract the current liabilities from current assets.
Here current assets refer to the cash and assets that can be liquidated easily within a year. These assets comprise of accounts receivables, inventory, and short-term investments.
Current liabilities refer to the short-term debts that need to be settled within a year. Such liabilities include accounts payable, sales tax, staff payments and wages, overdrafts, etc.
Ideally, businesses should aim to have more current assets than current liabilities. More current assets mean the business has positive working capital. If the current assets are lesser than your current liabilities then you may face a capital deficit. In such cases, you will face problems in repaying your creditors.
The Working capital ratio is a financial metric that is used to understand the financial health of your business. The ratio is measured using the above-mentioned formula which is
Working capital ratio = Current assets/ current liabilities.
This formula allows you to determine the amount of operating capital you need to repay your short-term debts. If the ratio is below 1 then it indicates negative working capital and a working capital ratio above 2 indicates the business has excessive working assets and has a large amount of cash tied up in inventory and debtors.
Ideally, the working capital ratio should be in the range of 1 to 2. This ratio allows businesses to make informed decisions. It is a statement that helps investors understand how efficiently the business manages its assets and how well the business is running.
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