All About Working Capital – Definition And Its Different Types Explained
People interested in starting a business of their own are familiar with the term working capital. Every business organisation, large or small, performs based on its working capital management. Before you understand what it means, you need to know what is working capital in general, for a business organisation.
What is capital in business?
Business capital refers to the sum of money or funds required for any company to produce or provide their products or services to its customers. All businesses need a specified amount of capital to operate. The availability or shortage of working capital can make or break a small business.
The basic objective of working capital in a business is operational efficiency could be maximized so that profits could be easily earned and operations could be performed smoothly. It also includes the concept of inventory management and supply chain management to successfully maintain accounts receivables as well as payables.
Working capital is a part of the entire equity for a business and refers to the money required to ensure the smooth running of the company. It is the liquidity of a firm for its daily operations and activities. This capital for business indicates how efficiently the company can handle its liabilities with its current assets.
What is Working Capital Cycle?
Working capital cycle means the amount of time taken to convert net current assets and liabilities into cash. If the cycle takes place for a prolonged period, then it means the business has its capital tied up with the working capital and does not earn any return on it.
So, companies try to lessen their Working capital cycle or WCC by collecting their receivables quickly. They can also do it by stretching their payable accounts.
The life working capital life cycle of any business organisation needs a thorough explanation here.
Consider some factors –
- When does it start?
- How to speed up the cycle?
- Why do some organizations have a longer cycle?
- Why is a shorter WC much better?
These are pertinent issues that need to be addressed. The working capital management, thus, forms a crucial aspect to understand it in a true sense.
WCM refers to a business’ strategy on managerial accounting. It is designed to monitor and also use the two fundamentals of working capital – current assets and current liabilities.
The principal aim to manage the working capital is to ensure the company preserves adequate cash in order to meet its short term operating costs as well as short term obligations on debt.
The WC equation is mainly – current assets/current liabilities.
The working capital cycle falls apart if one neglects its management. It proves to be a reflection of the company’s revenue collection, inventory management, supplier payment details and debt management. If you need to have an effective WCM, then you must utilise –
- Key performance ratios
- Inventory turnover ratios
- Collection ratios
Managing all these helps you maintain liquidity as well as healthy profitability.
Here is a look at the different types of capital. These working capital types are based on balance sheet or operating cycle view. One of the types is based on value while another one is based on time. Let’s we have a discussion on these working capital types below:
- Types based on the Value
Businesses divide working capital into two concepts, namely, net concept and gross concept based on value.
- Net concept- This concept refers to the excess current assets that remain for the company after paying off all its liabilities. It is always positive, as it relates to the extra capital.
- Gross concept- This concept refers to the total sum of money or assets available to the company for immediate liquidation. Gross working capital provides liquidity for the company within one year. It can be negative, positive or nil.
- Positive- As the name suggests, the positive gross working capital refers to a state of the company where the current assets outweigh the current liabilities. Positive state indicates the firm has strong finanical assets available.
- Negative- If a company’s liabilities are more significant than its current assets, it has a negative gross working capital. Such a state is not ideal for business and sustained negative equity will result in operations stopping.
- Zero- Zero gross capital means that the current liabilities and current assets for the business are equal. If your company has just enough money to operate its day-to-day activities without any excess, it is maintaining zero working capital. Such a state is not profitable and sustained periods with nil capital will push the firm toward insolvency.
- Types based on Time
Working capital can be divided into two parts, based on the time of its availability for the business.
- Permanent- The minimum funds that any company requires to operate day-to-day activities is the permanent capital.
- Temporary- The money that helps the company meet short-term needs is the temporary capital. These funds help stabilise the financial deficit a company undergoes due to fluctuating sales. It is also known as variable working capital.
Battling insufficient capital for your business
While maintaining positive working capital is ideal, most companies struggle to support such a level of liquidity. Business loans are a popular method to deal with insufficient capital. Loans offer an instant opportunity to rectify your capital deficit and get it back on track.
Features and benefits of business loans are as follows.
- These loans are high-value, meaning they provide a substantial amount of money. The more significant sum helps offset major capital deficits and prepares your business for its growth phase.
- Flexible tenors allows business owners to repay the borrowed sum within a period of their choice.
- Several reputed NBFCs provide business loans at affordable interest rates. The reduced rates limit your company’s overall liabilities.
- You can also reduce your EMIs further with Flexi Loans offered by top lenders
- Pre-payment and foreclosure options are also available. However, charges for the same vary from one financing company to another.
If your business suffers from insufficient working capital, ensure you opt for a business loan and save your business.