Working Capital also known circulating capital, fluctuating capital and revolving capital is one of the crucial ingredients of the company, which is concerned with short term financial decisions, operating efficiency and liquidity. Efficient working capital ensures good health of the company. In order words it refers to capital required for day to day operations of a company. Working Capital is excess of current assets over current liabilities. If working capital level is not managed efficiently it may result in blockage of resources that are helpful in daily operations of a company.
Current Assets: Those assets that can be converted into cash within the period of one year and also include those that are required to meet daily operations.
- Cash and bank balance
- Short term advances
- Prepaid expenses
- Inventory of raw materials (stores and spares)
- Inventory of work in progress and finished good.
Current Liabilities: Those claims of creditors that are to be paid within a year.
- Outstanding expenses
- Short term borrowing
- Advances received against sales
- Taxes and dividends payable
Uses of Working Capital
- It helps in improving Return on capital employed (Roce), by optimising investment in current assets and reducing current liabilities.
- It improves liquidity power of the company so that it can meet its current obligations with amount of current assets available in the firm.
- It ensures maintaining proper balance between current assets and liabilities in order to meet day to day obligations.
Working Capital can be divided into:
- Concept based working capital
- Time based working capital
Concept based Working Capital
It can be further divided into:
Gross Working Capital: It refers to company’s investment in current assets.
Making investment in fixed and current assets may result in profit for the company. Overall increase in investment results in increase Working capital.
Net Working Capital: It is the difference between current assets and current liabilities, which indicates liquidity extent of the company and working capital needs that are to be financed. Further it can be subdivided into:
- Positive Net Working Capital: It represents excess of current assets over current liabilities.
- Negative Net Working Capital: It represents excess of current liabilities over current assets. It will adversely affect the daily operations and profitability of the company with the situation of either closure of the business or becoming insolvent.
Time based working Capital: It can be further divided into:
- Permanent Working Capital: It is the minimum level of working Capital that a company needs to maintain constant. It can be also called fixed working capital. It is the irreducible amount that a company needs to maintain, it is locked up in the business and also known regular working capital. These type of assets that need to be maintained includes; stock of raw material, stock of work in progress, stock of finished goods, debtors balances etc and these are to be financed by from long term debt and equity.
- Temporary Working Capital: It is also known as fluctuating working capital. It is dependent on changes that occur due to change in production and sales. It is the extra working capital that is needed to support fluctuating business activities. It refers to additional assets that can be required throughout the year. And these types of Working capital are financed by short term debts. Example: requirement of product increases with change in taste and preferences: demand for lights increases during festive seasons.
Advantages of Positive Working Capital
- Positive and adequate amount of working capital helps in maintaining liquidity and solvency of the company.
- It helps in enhancing goodwill of the company, as it enables business to earn profits.
- Positive working capital and good credibility helps company in easily getting loan.
- Positive working capital enables regularity in daily operation of the company.
- Company with positive working capital is a profit earning concern, thus indicating a good investment opportunity for investors.
- Positive working capital enables a company to fight in the situation of crisis.
Disadvantages of Negative Working Capital
- If a company has negative working capital it is unable to take up future changes.
- If company has negative working capital it cannot be overcome by fixed assets.
- Negative working capital result in reduction of daily operations and profits.
Negative working capital cause improper financial conditions resulting in suffering for company and its members.
- Due to negative working capital there is loss of cash discounts, which other ways would have avail cash discounts on purchases which company makes.’
- Negative working capital result in fall in goodwill.
- It would be difficult to arrange for finances from banks and other institutions
A company should not have excess of working capital as it may result in:
- Excess working capital may cause unnecessary buying of goods.
- It also results in more debtors impacting credit policy.
- Excessive working capital may also result in some ideal funds.
Thus, working capital is one of the main components of the company which looks after the profitability and daily operations of the company. Thus, it is required to maintain adequate working capital as it is one of the measure through which investor can know whether his investment will give a fruitful return or not.