Establishing a business comprises investment of fixed capital that supports the underlying structure. However, operating it on a day-to-day basis requires the use of working capital (WC), a type of financing that helps maintain a business’s cash flow.
The requirement of working capital varies from one business to another depending on its type of operation, size, the operating cycle and other factors. Maintenance of optimum working capital or net working capital in a business is essential as it helps uphold its liquidity and financial health. Business owners should, therefore, be aware of the working capital their company carries at all times.
Take a look at other necessary details about a business’s working capital to understand its types, requirements, working and calculation better.
Networking capital – A brief overview
The WC of a company comprises its current assets and current liabilities. It is arrived at by deducting the current liabilities from current assets. The result is either net working capital or working capital deficit.
Businesses finance their working capital requirements through various sources in the beginning. However, in cases of a working capital deficit, they need additional financing to meet the shortage. It is essential to meet this gap as a shortage can result in reduced liquidity and the company’s inability to meet short-term liabilities.
You can, therefore, source the required additional funds for your business through loans and advances available as working capital financing. Lenders bring these customized options as business loans of high value.
Working capital – The types you must know about
A business may have different types of working capital that it utilizes to meet its operational financing requirements. It can be divided depending on your company’s operating cycle, its Balance Sheet and more. Based on current assets and current liabilities listed in the Balance Sheet, it can be divided into gross and net working capital.
From the perspective of the operating cycle, it can be divided into permanent and temporary working capital. It also has a classification as long-term and short-term working capital based on the period it is utilized in the business. The working capital formula employed to calculate each of these classifications differs.
Working capital cycle – The concept
WCC or working capital cycle refers to the time a business takes to convert its current assets and liabilities into cash and cash equivalents. It helps determine a business’s liquidity and serves as a parameter of organizational efficiency.
The longer this life cycle of working capital, the more time it will take for your company to acquire liquidity and free up the cash blocked. A shorter WCC shows that the business can efficiently manage its cash flow through timely payment of short-term liabilities and recovery of dues.
Calculation of working capital
The most prevalent working capital formula used for WC calculation of all businesses, whether large or small is given below.
WC = CA – CL, whereby CA denotes current assets, and CL stands for current liabilities.
The business’s liquidity position can also be determined through the WC ratio, which is the ratio of current assets to current liabilities. A ratio of 1.5 to 2 is considered healthy, while this ratio falling below 1 shows a WC deficit. Also, if it exceeds 2, the company has invested excessive cash to fund its WC requirements.
With this information on net working capital, you can estimate the funds invested or needed for your company. It is advisable to take correctional steps if the WC calculated is below the optimum requirement or exceeds the same. Also, you must avoid common mistakes when managing the working capital of your business to maintain smooth cash flow.