A company’s working capital denotes its liquidity levels at any given moment. Having a steady working capital flow, or the constant availability of liquid cash as well as non-cash current assets, is vital for any business to manage factors such as inventory, salaries, debt management, and growth initiatives. Therefore, getting an in-depth understanding of working capital, its working mechanism, its components, advantages, and other elements can help organizations optimize the management of their liquidity levels better.
What is Working Capital?
From an accounting standpoint, working capital is the difference between an organization’s current assets and current liability values. This is a figure that changes relentlessly as the current assets — which include, amongst others, cash, inventory, and accounts receivable — and current liabilities — which include, amongst others, wages, interest owed, and taxes — change with time. The working capital of an organization is one of the most accurate indicators of how well or poorly it is doing regarding its financial management.
| Working Capital | = | Current Assests (₹) | - | Current Liabilities (₹) |
|---|---|---|---|---|
| Inventory, Cash equivalents,Accounts receivables, Stock inventory, Marketable securities, Prepaid liabilities, Other liquid assets, Short-term deposits, Office supplies, Other current assets | Interest owed, Accounts receivables, Trade payables, Outstanding overheads, Short-term loans, Mortgage loans, Bonds, Debentures, Lawsuits, Warranty, Deferred revenue, Current maturities of long-term debts, Interest payable on outstanding debts, Income taxes | |||
If the current liabilities in an organization exceed its current assets, then businesses end up having negative working capital values.
Working capital is also known as circulating or revolving capital due to its frequently volatile, regenerative nature.
Why is Working Capital Important?
Apart from denoting the financial situation of a company at any given point in time, working capital is critical for several other reasons.
- A Key Indidcator
Nearly every major decision taken by the management of an organization is based on whether funds are available for day-to-day functioning or not. Based on its working capital, the finance and accounting team in an organization can manage its current and future resources through trade financing and create realistic budgets for various growth strategies.
- A Reliable Liquidity Regulator
The readily available cash or liquefiable assets an organization possesses directly or indirectly affects the speed and efficiency of its daily operations: procurement, production, packaging, drayage services, and others. Organizations that have a measure of control over their working capital can ensure that these elements never dip below acceptable standards.
- An Accurate Creditworthiness Evaluator
An enterprise that manages its working capital competently can ensure that it never slips into negative values. This boosts its ability to make payments and repayments on time to vendors, creditors, banks, and other entities. Ultimately, that reinforces its credit score.
- Can be used to fund growth
This is particularly true for growing businesses. Various working capital solutions exist in the market for businesses to secure at reasonable interest rates and use the same to procure raw materials, manage payments and earn a profit on the amount.
This can help a business earn profits on capital it does not own but capital that it managed to secure due to prudent working capital management.
What Are the Advantages Of Working Capital?
As it plays so many roles, having a healthy working capital is hugely beneficial for organizations. Some of the positives of healthy working capital are:-
- Fewer Operational Challenges A significant part of working capital management involves an in-depth analysis of financial ratios. The analysis and usage of metrics such as capital ratio, accounts receivables turnover ratio, quick ratio, and others, gives businesses control over the planning and execution of their daily operations. If there are unwanted fluctuations in these metrics, a business can identify and address the areas in working capital management that require optimization. Thus, a healthy working capital is helpful for continuity from a budgetary and planning standpoint.
On a more basic level, the ready availability of liquid cash enables businesses to never run out of resources such as raw materials, personnel, power supply, amongst others, keeping their fundamental operations running smoothly. The availability of liquidity brought forth by effective working capital management helps businesses maintain continuity and prevents unnecessary interruptions in their daily functioning.
Higher Profitability
If maintained, working capital helps businesses maintain adequate levels of inventory and prevent operational breakdowns. Additionally, the recovery of receivables is also made efficient. All these add up to more efficient revenue collection and higher profitability.Better Bargaining Power Liquidity is a powerful tool for negotiations. Essentially, having a high liquidity level allows businesses to dictate terms when it comes to bargaining in trade agreements. For instance, companies that can pay advance fees for raw materials can also demand suppliers to offer discounts on their prices.
Greater Goodwill As stated earlier, businesses only optimize their working capital by following a stringent work ethic and following through with all their commitments. This fosters a solid credibility for businesses and, as a result, boosts their reputation.
What are the 4 main components of working capital?
Working capital consists of two main parts — current assets and current liabilities. This can be classified into a quartet of components that determine the actual, real-time working capital of an organization.
Trade Receivables
Trade receivables is a term used to denote the money that is owed to a business by its debtors. Trade receivables normally appear on the balance sheet of a business in the form of sale invoices, or other documents in which its customers assure future payment for goods purchased on credit. Receivables are enlisted as current assets on the balance sheet of a company. For example, if A sells goods worth INR 12,000 to B on credit, B can take the delivery of the purchase and receive an invoice from A. On its balance sheet, A will list INR 12,000 as trade receivables.
Inventory
Inventory is an exhaustive list that contains a complete list of assets that a company owns. Inventory includes assets such as property, raw materials, goods in stock, machines, or the contents of a work building. All inventory entities fall in the current assets category in the balance sheet.
Cash and Bank Balances
As the terms imply, cash and bank includes the deposits made, credit balances, and other sums that a company has stored with financial institutions, and also the liquid cash it has available that can be used immediately. Cash and bank balances are enlisted as current assets in the financial documents of an organization.
Trade Payables
Trade payables is the term used to denote the money that a business owes to its creditors such as suppliers and financial institutes (for borrowings). This is a current liability for businesses. For example, if A Ltd purchases raw materials worth INR 15,000 from its supplier C Ltd on credit, this entry will be added to the trade payables section in the current liabilities part of A Ltd’s balance sheet.
What are the eligibility criteria for a Working Capital Loan?
The most important eligibility criteria for any loan is the applicant’s creditworthiness. When you apply for working capital loans from banks and other NBFCs, they investigate your creditworthiness by a variety of parameters -- knowing your business, deep-diving into your and the company's financial statements, etc. The detailed criteria for securing a working capital loan are different for every business. Most traditional banks gauge your application on the following parameters:
- Applicant’s and the Company’s Bank Statements
- Company’s Balance Sheet
- Proof of Time in Business and Business Continuity
- The Applicant’s Credit Score
- Applicant’s and the Company’s Tax Reports
- Collaterals/ Assets owned by the Applicant and the Company
What are the documents required for a Working Capital Loan?
Although the exact list of documents required to get a working capital loan depends on the nature of business of the applicant as well as the policies of the lender, here are the most commonly required documents:
- PAN Card
- Passport Sized Photographs of the Applicants and the Co-applicants
- Identity Proof
- Address and Income Proofs
- Business Continuity: Last three years’ income tax return (ITR) and bank statements
- Credit Monitoring Arrangement (CMA) report, if business' turnover is more than Rs 5 cr
- Last two years’ of the audited financial report
- Partnership deed
- Certificate of registration
- Certificate of incorporation
- In the case of multiple directors, the name of all the present directors on company letterhead
- Memorandum of Association (MoA) and Articles of Association (AoA)
How to apply for a working capital loan?
Once you decide to aquire working capital loan for your business, here is how you can apply for it:-
- Explore your options as to which Bank, NBFC or alternative financing company do you wish to apply to and compare their rates.
- Once you figure out which option is best suited to your needs, contact the lender on their website or visit their branch near you.
- Apply for a loan by submitting the required documents.
- Once the lender approves your application and sanctions the loan, the amount is credited to your bank account within a stipulated period.
How Do You Calculate Working Capital?
The formula to calculate working capital is given as follows:
Working Capital = Current Assets - Current Liabilities
In a balance sheet, the working capital of an organization would read as:
In this hypothetical financial document, the working capital of the organization will be Total Current Assets - Total Current Liabilities = INR 54,500 Crs – INR 40,000 Crs = INR 14,500 Crs
Here’s another example of working capital :- A Ltd's balance sheet shows the company's current assets valued at INR 3,00,000. This amount consists of the monetary values of accounts, receivable, cash and bank, stock (including procurement materials, work-in-progress, finished goods, and packaging), and short-term investments. A Ltd's current liabilities include bank overdrafts, rent, outstanding expenses, payroll, accounts payable and short-term loans totaling up to INR 1,80,000. The working capital of A Ltd is INR 3,00,000 - INR 1,80,000 = INR 1,20,000.
What is the working capital cycle?
The working capital cycle is the time a company takes to convert its net current assets and current liabilities (by repayment) into liquid cash. A longer cycle, then, essentially, means that the capital is tied in liabilities for longer periods, preventing returns on investments. Generally, businesses need to maintain cycles that are as short as possible. Long working capital cycles translate into tying up capital for longer without getting a return on investments made.
To shorten the working capital cycle, businesses need to know its main components to address issues, if any and address them. Some of these components are: healthy, positive cash flows, trade receivables, inventory, and billing cycles.
Based on these elements, the working capital cycle formula is:
Working capital cycle in days = Inventory days + receivable days - Payable days
- Inventory days stands for how long it takes for a business to sell their inventory.
- Receivable days is the average number of days a customer takes to repay a business for products or services they buy.
- Payable days is the average number of days it takes for a business to get rid of its accounts payable by paying them to its creditors.
What Are the Types of Working Capital?
While the basics of working capital, more or less, remain the same, different terms can be used to describe working capital during different phases. Some such terms include:-
Temporary Working Capital
This is the working capital needed only during certain phases throughout the year. For instance, the capital that is raised during seasonal sales. Generally, these situations are temporary and change as per the operations and market situations pertaining to a given business. This also means that businesses may need short-term loans to fund their operations and can repay them soon after, when they have money.
Permanent Working Capital
This is the minimum capital required for businesses to function without stoppages. It involves the money used to make liability payments even before businesses are able to convert their assets into cash. Businesses generally need a long-term, permanent solution to offset such liabilities. This is also known as hardcore working capital or fixed working capital.
Special Working Capital
This kind of working capital is even rarer than temporary working capital. For instance, if a company raises cash to organize a once-a-year football tournament, the spike in current assets are classified as special working capital.
Reserve Working Capital
This is the capital amount that an organization maintains over and above its standard working capital. Some businesses call this contingency working capital due to its use in emergencies.
What is a working capital ratio?
The working capital ratio is also known as the current ratio. It is indicative of a company's liquidity, and its financial ability to meet its payment obligations.
Working capital ratio is given by:
- Current assets/Current liabilities
This ratio should ideally be higher than 1 to indicate that the working capital of a business is healthy and flexible enough to accommodate any projects. Even in case the ratio is higher than 1:1, businesses may struggle, depending on how quickly they can sell inventories and collect accounts receivable.
Is Negative Working Capital Bad?
In most cases, businesses may not want a negative figure for their working capital. However, a negative working capital figure may not be a worst-case scenario for several businesses. For instance, in the short term, it may indicate that a business is very efficient in bargaining with its suppliers. In certain cases, such as while seeking bank financing, lowered or negative current assets can help businesses face lower payable interest rates.
However, in the long-term, having a negative working capital is not ideal as it paints the picture of a business frequently running into losses.
What is Positive Net Working Capital?
A positive net working capital indicates that an organization has funds available for use and can sustain itself without falling into bankruptcy.
Limitations of Using Working Capital
- One of the challenges of working capital is that it just shows the financial health of a company, but does not indicate any measures to remedy problems.
- Working capital ratios can be challenging to decipher. In other words, companies may not know the numerical limits up to or beyond which working capital ratios are useful.
- Another criticism of working capital is that it does not acknowledge the changes taking place in the market. Working capital is just a difference between two balance sheet entities.
How Can a Company Improve Its Working Capital?
In the short-term, businesses can use options such as bill or invoice financing to raise capital. The funds received through these financing options do not show on the balance sheet of businesses, thereby improving their liquidity (cash), while not increasing their current liabilities at the same time. Another simple and quick fix is paying vendors and other creditors as early as possible so that debt does not accrue over time.
Some long-term measures to optimize working capital are:
- Reducing the lead time of logistics operations.
- Utilizing trade credit insurance.
- Reducing bad debts by choosing debtors carefully.
- Cutting unnecessary expenses.
- Monitoring assets and liabilities continuously.
FAQs on Working Capital Loan
1. What is the difference between working capital and term loan?
Working capital loans are a short-term loan availed to manage the day to day expenses, while term loans are generally medium to long term loans and borrowed keeping in mind a long term goal.
2. Where does working capital loan go on a Balance Sheet?
Since a working capital loan is a part of short term debt, it is reported as a liability on the company’s balance sheet.
3. Is Negative Working Capital Bad?
In most cases, businesses may not want a negative figure for their working capital. However, a negative working capital figure may not be a worst-case scenario for several businesses. For instance, in the short term, it may indicate that a business is very efficient in bargaining with its suppliers. In certain cases, such as while seeking bank financing, lowered or negative current assets can help businesses face lower payable interest rates.
However, in the long-term, having a negative working capital is not ideal as it paints the picture of a business frequently running into losses.
4. What is Positive Net Working Capital?
A positive net working capital indicates that an organization has funds available for use and can sustain itself without falling into bankruptcy.
