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Meaning Of Working Capital
Working capital is the measure of the liquidity of a business. It shows how much current assets are generated by the business to pay off your current obligations. Working capital is the excess of current assets over current liabilities. As the term indicates, it is the liquid capital required to manage the day-to-day operations of your business efficiently. Working capital management plays a crucial role in the smooth functioning of a business. In short,Working Capital = Current Assets - Current Liabilities
Types Of Working Capital
Find the broad categories of working capital used in business
Permanent Working Capital
It is the minimum amount of working capital a business needs for the smooth running of day-to-day business operations. Any business should have this amount of permanent capital as liquid cash in hand or at the bank. They cannot wait to convert their finished goods or receivables into cash. It is also called the fixed working capital of a business.Temporary Working Capital
It is the working capital required to meet seasonal or unforeseen market demands. A cloth retailer will require higher working capital during Diwali than in the normal period. The business can fund the gap with external working capital financing and repay them in a short period.Special Working Capital
Special working capital is a kind of reserve working capital to meet unforeseen situations and emergencies. For example, in case of fire, the business may require a high amount of working capital to repair the damages and start the business afresh. It is also known as special variable working capital.Gross Working Capital
It means the current assets of the business like cash, inventory, receivables, and short-term investments. It does not by itself present any clear picture of the liquidity or funding requirements of a business. It should be compared with current liabilities to have a holistic view.Net Working Capital
This is the actual working capital of a business. The net of current assets and current liabilities is called net working capital. This is the actual measure of assessing the financial soundness of a business. The net working capital represents how well the business is quick in settling the current obligations using its internal current assets rather than external finances.Variable Working Capital
It varies according to the growth of the business. When the business expands its market by adding a product line or by geographical presence, there will be an additional working capital requirement. Variable working capital helps in identifying the additional demand for working capital in case of business growth.Reserve Margin Working Capital
This works more or less like a special working capital but includes all the possible circumstances where there will be a sudden spurt in working capital requirements. The reserve margin working capital is maintained over and above the fixed working capital requirement and is not used unless the actual situation arises.Components Of Working Capital
Current Assets
Current assets are the assets convertible into cash within one year. These are the assets readily available to meet your current obligations. The current assets include- Cash and cash equivalents
- Inventory
- Short term investments
- Trade receivables or sundry debtors
- Prepaid expenses
Current Liabilities
Current liabilities are the obligations arising out of the normal course of business that is repayable within one year. The current assets of the business are used to settle the current liabilities which include- Trade payables or sundry creditors
- Outstanding expenses
- Short term Personal loans
- Short-term advances or unearned revenues
Purpose Of Working Capital
- Smoothen the operating cycle of Sales to Receivables to Cash Inflow and Purchases to Payables to Cash Outflow
- Reduce the cost of maintaining the working capital and optimise investment
Benefits Of Optimum Working Capital
- Helps in smooth and efficient business operations.
- Builds the core strengths of the business by focusing on the main activities.
- Helps in avoiding cash crunches.
- Promotes and maintains healthy relationships with vendors.
- Increased sales by reducing the inventory cycle.
- Timing the vendor payments rightly.
Also Read: Apply for Small Business Loans
What Is The Optimum Working Capital
The current assets must always be more than the current liabilities to have optimum working capital. The working capital ratio or current ratio is calculated by dividing current assets by current liabilities. The resultant figure can be somewhere between 1.5 and 3 as an optimum working capital measure. But it also depends on various factors like
Nature of business operations
A manufacturing company may have larger priorities on investing in fixed assets like plants and machinery and equipment. A trading company will consider investing its money in maintaining inventories and other operational expenses. Hence the working capital requirement varies depending upon the intensity of the business.Size of the business
The size of production and sales highly influences the amount of working capital the business should maintain.Business Cycle
There is always a time lag between raw materials being converted into output, the finished products converted into sales and the sales receivables converted into cash. When there is a lag in converting sales into cash, the businesses rely on external working capital finances to bridge the gap.Also Read: What is a Good Credit Score for Business Loan?
Market Demands And Fluctuations
A business is always under the pressure to perform for market demands and the working capital is nowhere an exception. The extent of the working capital requirement is also highly influenced by market fluctuations in which the business operates.Conclusion
Working capital is considered very important since it revolves around the main operating activities of a business. The businesses are largely dependent on external financing to bridge the working capital gaps to have uninterrupted production and supply. Hence it is imperative to have an efficient working capital management system to assess the dynamic working capital requirements of a business. The businesses that manage working capital efficiently are bound to perform beyond milestones even in turbulent times.
FAQs Of Types Of Working Capital
1. Is gross and net working capital the same?
No. Gross working capital is the sum of current assets, whereas net working capital is the amount by which current assets exceed the current liabilities.
2. What is working capital management?
Working capital management encompasses inventory, production, sales, and treasury management as a whole and arrives at the optimum cycles suitable for the business as such.
3. What is working capital financing?
Many banks and financial institutions provide working capital finances to credit-worthy businesses to bridge the working capital funding gaps. They are short-term finance and carry a lesser rate of interest compared to term loans.
4. What are the types of working capital finance?
Cash credit, overdraft, letter of credit, invoice financing. Bill discounting, and bank guarantees are the most popular forms of working capital finance.
5. What is the eligibility for getting working capital finance?
The business must be in existence at least for a year with good profitability and credit score.
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