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.
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.
Some of the reasons why companies must focus on their working capital levels are:
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 company’s working capital status.
Here is how a company’s low working capital levels can be interpreted:
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.
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.
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