Working Capital - Types and Examples
Working capital is the difference between the company’s acquired current assets and current liabilities. Another term for Working Capital is Net Working Capital or NWC, this is the measurement of the company’s liquidity status, this also determines the operational efficiency and the short-term financial health of the company can also be detected by this tool.
In this content, we are going to discuss ‘What is Working Capital?’ where students will get a clear understanding on the concept of Working Capital, how working capital impacts a company and way to calculate it will be consisted in our discussion.
What is Working Capital?
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Working Capital, meaning in accounting language, is a method which is used to indicate the financial position of a firm or a business organization. Though this tool is only used for a short time basis, it proves to be a great analyser if you want to know about the liquidity or financial condition of the business in a short span of time. This is a scale to measure the overall performance and efficiency of the business entity.
If you want to calculate the working capital of a specific firm or any organisation you only need to subtract the current liabilities from the total current assets present in the business. The ratio which comes out as an answer suggests whether the particular organization has enough assets with it which will in turn help in the payment of the short-term debts.
In simpler and direct terms, we can say that working capital is nothing but an indicator of the liquidity levels in an organization which will suggest if the business is capable of taking care of the day-to-day expenditure and cash, accounts payable, inventory, accounts receivable, and at the same time the due short-term debt.
This working capital is acquired from many operations of the company like the inventory and debt management, the revenue collection, and paying to the supplier.
Working Capital Example
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Working capital refers to the amount required for the purpose of financing the daily operation. Like - Working capital of Rs.100,000 with the business owner is being calculated by subtracting the current liabilities of Rs. 200,000 from the current assets which are Rs. 300,000.
Working Capital Example:
Cash and cash equivalents. To note, Cash equivalents are highly-liquid assets, it includes money-market funds and treasury bills.
Funds in checking or in the savings bank account.
Marketable securities also come under working capital like stocks, mutual fund shares, and some types of bonds.
The Relation between The Components of Working Capital
The relation is depicted in the formula itself:
The working capital can be negative for a company whose current assets are less than its current liabilities. Now let us know about the types of Working Capital in the following section.
Types of Working Capital
The types of Working Capital are as follows:
Positive Working Capital: A company that has more current assets than its current liabilities, has positive working capital. This type of company has enough working capital which acts as an assurance of fully covering the short-term liabilities as and when they become due in the following twelve months. Having a positive working capital signifies a company's financial strength.
Zero Working Capital: When a company has exactly the same amount of current assets and an equal amount of current liabilities, then there is the situation of zero working capital in place. This situation will exist if the company is totally funded by its current liabilities. Having a zero-working capital, potentially increases the chance of investment, while it also signifies financial risks.
Inside Negative Working Capital: The negative working capital is very much closely related to the factor of the current ratio which is being calculated as - current assets divided by its current liabilities. If a current ratio comes to be less than 1, then the current liabilities exceed the current assets and thus the working capital turns negative.
Did You Know?
Working Capital helps in making the long-term strategy as well, not only the short-term strategy.
Working capital helps in monitoring the cash regularly.
Working capital is used as a benchmark against other competitors.
By calculating the working capital, one can also encourage the customers to pay on time.
Working Capital is to be used in a full-fledged manner in a business, not only in downtimes.
Businesses might not talk about working capital every day, but this accounting method is a key to the company’s success. Working capital affects many vital aspects of the business, from paying the vendors to keeping the electricity going, working capital funds important facets in day-to-day business activity.
FAQs on Working Capital: Meaning, Types, and Management
1. What is working capital in simple terms?
Working capital is the money a business needs to cover its short-term, day-to-day operational expenses. It is essentially the difference between a company's current assets (like cash, inventory, and accounts receivable) and its current liabilities (like accounts payable and short-term debts). It measures a company's operational efficiency and short-term financial health.
2. What is the difference between Gross Working Capital and Net Working Capital?
The primary difference lies in what they represent. Gross Working Capital is the total sum of all current assets of the business, representing the overall investment in short-term assets. In contrast, Net Working Capital is calculated as Current Assets minus Current Liabilities (CA - CL). Net Working Capital provides a more realistic picture of the company's liquidity and its ability to meet its short-term obligations.
3. What are the main components of working capital?
The main components of working capital are divided into current assets and current liabilities. The key components are:
Current Assets: Cash and bank balances, inventory (raw materials, work-in-progress, finished goods), trade receivables (debtors), and short-term investments.
Current Liabilities: Trade payables (creditors), outstanding expenses (like salaries and wages), short-term loans, and tax provisions.
4. What are the different types of working capital?
Working capital can be classified based on time and concept. The main types include:
Permanent Working Capital: The minimum amount of capital required to maintain the circulation of current assets continuously. This is also known as fixed working capital.
Temporary Working Capital: The additional capital required to meet seasonal demands or unexpected business fluctuations. It is also called variable working capital.
Positive Working Capital: Occurs when current assets are greater than current liabilities. It indicates good short-term financial health.
Negative Working Capital: Occurs when current liabilities exceed current assets. This may indicate a liquidity problem, but not always.
5. Can you explain the concept of working capital with a simple example?
Certainly. Imagine a small bakery. Its current assets include cash in the register (₹10,000), flour and sugar inventory (₹20,000), and money owed by a café that bought cakes on credit (receivables, ₹5,000). The total current assets are ₹35,000. Its current liabilities include payments owed to its flour supplier (payables, ₹8,000) and upcoming electricity bills (₹2,000). The total current liabilities are ₹10,000. The bakery's net working capital is ₹35,000 - ₹10,000 = ₹25,000. This ₹25,000 is the fund available to manage daily operations smoothly.
6. Why is managing working capital important for a business?
Effective working capital management is crucial for a business's survival and growth. Its importance lies in:
Ensuring Liquidity: It ensures the firm has enough cash to pay its short-term debts and operational expenses on time, preventing insolvency.
Increasing Profitability: By efficiently managing components like inventory and receivables, a company can reduce costs and improve its profit margins.
Improving Creditworthiness: A healthy working capital ratio enhances a company's reputation and makes it easier to secure loans from banks and creditors.
Uninterrupted Operations: It ensures a smooth production and sales cycle by making funds available for purchasing raw materials and covering daily expenses.
7. What is the working capital cycle?
The working capital cycle, also known as the operating cycle, is the time it takes for a company to convert its current assets and current liabilities into cash. It starts with purchasing raw materials and ends with receiving cash from the sale of finished goods. A shorter cycle is generally better as it means the company's money is not tied up in inventory or receivables for long, indicating higher efficiency.
8. What factors determine a company's working capital requirement?
Several factors influence how much working capital a business needs. Key determinants include:
Nature of Business: A manufacturing firm typically needs more working capital than a service-based firm due to inventory requirements.
Scale of Operations: Larger companies with higher sales volumes require more working capital.
Business Cycle: During a boom period, more working capital is needed to support increased production and sales.
Seasonal Factors: Businesses dealing in seasonal goods (e.g., winter wear) need higher working capital during peak season.
Credit Policy: A liberal credit policy (allowing customers to pay later) increases the need for working capital, while a strict policy reduces it.
9. How does negative working capital impact a company? Is it always a bad sign?
Negative working capital (where current liabilities > current assets) can signal that a company is unable to meet its short-term financial obligations, which is a sign of poor liquidity. However, it is not always a bad sign. For some businesses, like supermarkets or fast-food chains, it can be a sign of high efficiency. These companies receive cash from customers immediately but pay their suppliers later. This model allows them to fund their operations using the credit extended by their suppliers, which is a very efficient use of capital.
