Capital is the backbone of any business. Without sufficient capital, a business cannot stay up for long nor the functionality of working capital in an operational business. Working capital is said to be one of the most vital components of any business. Insufficient working capital leads to a shortage of resources thus, leading to increased losses in a particular business.
Why is working capital so vital?
Working capital is all about having an excess amount of current assets over the current liabilities. It forms a vital part of the business’s aggregate capital. Thus needs working capital for funding its short-term obligations. This kind of capital enables a firm to pay for its short-term dues and the daily incurring expenses.
Working capital is the sum of calculating a business’ position of liquidity, efficiency for business operations, and decent short-term finances. It is thus the overall Current Assets subtracted by the Current Liabilities.
For an in-depth understanding, let us explain current assets and current liabilities.
- Current assets- These are those types of business assets that can be converted easily into cash within a particular year or any operating cycle of business. This asset type typically includes inventory, cash and other cash-related equivalents, marketable securities, accounts receivable, prepaid expenses, and other liquid assets.
- Current liabilities- Current liabilities are those business obligations that are due within a year or one operating cycle, whichever is greater. These kinds of liabilities are generally paid off by utilising the other current liabilities. The current liabilities thus include notes payable, accounts payable, accrued liabilities, current portion of long-term debt, and unearned revenues.
Working capital and its types
Let us check out some of the major types of working capitals utilised by the businesses:
1. Permanent working capital
The permanent working capital is the money amount required to make the liability payments even before an individual can convert it into an invoice or assets into cash. This type of working capital is also known as the operating cycle. Most businesses need a permanent or ongoing solution to fill this gap. Also referred to as the fixed working capital, this is the minimum working capital required for the smooth functioning of the business.
2. Variable working capital
This kind of working capital can be defined as an investment for a temporary period in a particular business. That is why it is also known as the fluctuating working capital. This kind of capital varies whenever there is any change in the business size or business asset size. The variable working capital is subdivided into two other categories, which include:
- Seasonal variable working capital: This kind of working capital is essential during the peak season of a particular year. A business might be required to borrow funds for meeting its working capital requirements. That is why it is known as the seasonable working capital as it meets the requirement of a business having a seasonal nature.
- Special variable working capital: This kind of working capital may also be required in a particular business for undertaking unforeseen circumstances or exceptional operations. These are those funds necessary for fulfilling enforcing events like damage due to natural disasters or fire accidents.
3. Regular working capital
It is the least capital amount needed by a particular business to fund its business operations. Examples of working capital include payment of wages or salaries or other overhead expenses for processing resources.
4. Gross working capital
This kind of working capital refers to the aggregate fund amount invested in the business’s current assets. In other words, we can also define gross working capital as the total amount of current assets for a particular business. It includes short-term investment, marketable securities, inventory, accounts receivable, and cash. In this kind of working capital, one needs to compare the current assets with the current liabilities; to get a better explanation of the operational efficiency of a particular business.
Reserve margin working capital
Apart from regular activities, a business might require a capital amount for unforeseen circumstances. The reserve margin working capital is all about the amount of capital kept aside and separated from the regular working capital. This fund pool is separately kept for unforeseen situations like natural calamities, strikes, industrial accidents, etc.
1. Net working capital
The net working capital is the particular amount through which the current asset mainly exceeds the current liabilities of a particular business. Thus, the equation of working capital is defined as the difference between the current assets and current liabilities. The working capital amount in a business mainly indicates operational efficiencies, liquidity, and other short-term financial activities of a particular business.
Temporary working capital
It might be required in any business at a specific time of the year. For instance, temporary working capital is often required during festive seasons, owing to the various immediate demands of a business. This requirement is known as temporary as it is used for changes in business operations and the current market situations.
1. Negative working capital
A deficit or shortfall in a business is known as negative working capital. It reflects access to the current liabilities over the current assets. This kind of situation arises when the current liabilities cross the current assets. In other words, you can say that there is more short-term than as compared to short-term assets. In this kind of situation, a company might need to borrow funds from investors and suppliers. The negative working capital is one way through which a business grows sales with other people’s finance.
What kind of factors influence working capital?
Here are some of the factors that influence the working capital:
1. Business cycle
The business cycle has a significant impact on a business’s working capital. Often during the seasonal time, businesses typically expand, thus requiring an extra working capital. Additional funds are required during this period so that the business can expand. Funds are also required for buying raw materials and resources for generating better sales. In the same way, during the period of depression, there is a decline in the sales and production of goods and services.
2. Size and nature of business
The working capital also depends on the nature and size of a particular business. The need for working capital varies from business to business in between a small to a high amount. This working capital depends upon the type of industry. Also, the size of a business matters a lot in this regard, as companies with large-scale operations require more working capital than smaller firms.
3. Functional and operational efficiency
Various businesses have various operational efficiencies. Businesses with better functional efficiency are often required to invest less amount of funds in the working capital. Whereas businesses having poor operational efficiency require more funds for investment in the working capital.
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3) What is Financial Analysis? Types, Importance & Purpose.
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Q. What are the main elements of working capital?
Ans. Money coming in, going out, and inventory management are some of the elements of working capital.
Q. Can working capital be considered an asset?
Ans. Working capital is considered a part of an operating capital with other fixed assets like equipment and other resources.
Q. How can I maximise working capital?
Ans. Working capital can be maximised by earning additional profits, borrowing long-term finance, issuing common stock, converting long-term assets into cash, and so on.