Every business needs sufficient capital to function and meets its various operational needs. Capital helps businesses in day-to-day functioning and also achieve growth targets. The capital required by a business to cater to its routine or day-to-day expenses is called the working capital.
Working capital is mainly used for short-term capital needs. Let’s have a look at what this means and how crucial it is for businesses.
What is working capital?
The difference between a company’s current liabilities and its current assets is its net working capital. Thus, working capital helps understand a company’s liquidity and its operational efficiency. The higher the working capital, the stronger the company’s short-term financial health.
Since working capital is determined by looking at a business’s current assets and current liabilities, it tells us the amount of assets that the company is capable of converting into cash in the short run. Some of the current assets that can be converted into cash include the company’s bank balance, short-term investments, cash at hand, prepaid expenses, money due from debtors, etc.
Current liabilities, on the other hand, is the amount that the company owes in the short term. For instance, money owed to creditors, bank overdrafts, other outstandings, etc.
Why is working capital important for companies?
Some of the reasons why companies must focus on their working capital levels are:
- To cater to obligations: If a company has sufficient working capital levels, it will find it easier to pay its creditors, and employees, and meet other short-term obligations.
- Achieve growth: With good working capital levels, a company can plan to achieve certain growth levels without borrowing capital.
- Enhanced creditworthiness: A company that has a positive working capital balance will find it easier to borrow loans and other forms of credit.
- Target short-term profitability: With positive working capital, a company can set aside the excess funds towards short-term investments and earn profits from the same.
- Goodwill: With positive working capital, a company can maintain goodwill and an overall positive image of its cash management abilities.
- Minimal revenue fluctuations: Seasonal businesses that maintain sufficient working capital levels can ensure that all their financial obligations are met irrespective of the current phase of business.
- Easier expense management: With a favourable working capital balance, companies can ensure that they do not have to face a cash crunch in case an unexpected expense comes up.
Did you know
Investors often look at a company’s financial statements to estimate ratios like current ratio, quick ratio, inventory turnover ratio, etc to gauge its working capital status. These help understand the short-term liquidity position of a company.
Read More : How quick ratio helps you determine a company’s working capital status.
What if a company has low working capital?
Here is how a company’s low working capital levels can be interpreted:
- A low working capital means that a company has low current assets as compared to its current liabilities. From a long-term perspective, a low net capital, however, does not necessarily mean that company is incurring losses.
- Working capital levels are indicative of a company’s short-term financial health. The poorer a company’s financial health, the fewer investors and creditors it will attract. However, it could also mean that the company has allocated more funds towards investments that fetch higher long-term returns.
- Low working capital may also result in a company being unable to meet its financial obligations. However, if a company adheres to its financial obligations despite low working capital, it indicates reliability and optimal financial management.
- A company carrying negative working capital for many months or a few years could turn bankrupt in the long run.
Conclusion
Working capital management is simply how well a company manages its working capital, whether its current assets are higher or lower than its current liabilities. Companies cannot undermine the importance of working capital management due to the factors discussed above. Appropriate working capital management helps companies maintain sufficient liquidity levels, enhance their operational efficiency, reduce interest costs, and push up their overall profitability.
FAQs
Some of the categories of working capital include gross working capital, net working capital, permanent working capital, regular working capital, reserve margin working capital, and variable working capital.
Some of the ways in which companies can effectively manage their working capital are by appropriately managing procurement and inventory, making timely payments to vendors, improving the receivables process, and effective management of debtors.
A working capital loan is a business loan used by companies to meet their short-term goals by financing their operational requirements. This type of loan can ensure that the business is able to continue its operations smoothly in the short term.
An ideal working capital ratio is between 1.2-2.0. This indicates that the business has good financial health. A working capital ratio of 1.2 indicates that the business has sufficient current assets to cater to its current liabilities. A ratio above 2.0 indicates that the business is unable to manage its capital effectively.
