Working capital is a financial metric that indicates the liquidity levels of businesses for managing day-to-day expenses and covers inventory, cash, accounts payable, accounts receivable, and short-term debt. It is an indicator of the short-term financial position of an organisation and is also a measure of its overall efficiency.
 

Concept of working capital

Working capital, or net working capital (NWC), measures a company’s short-term financial health by subtracting current liabilities from current assets. Current assets include cash, accounts receivable, and inventory, while current liabilities encompass accounts payable and short-term debts. Positive working capital indicates a company can easily cover its short-term obligations and invest in operations, reflecting its financial efficiency.

Components of working capital

Working capital represents a company's short-term financial health and operational efficiency. It is calculated by subtracting current liabilities from current assets. The primary components of working capital include:

1. Cash and cash equivalents: Readily available funds that a company can use to meet immediate obligations. This includes physical cash, bank balances, and short-term investments that can be quickly converted into cash.
2. Accounts receivable: Funds owed to the company by customers who have purchased goods or services on credit. Efficient management ensures timely collection, which is crucial for maintaining liquidity.
3. Inventory: Comprises raw materials, work-in-progress, and finished goods available for sale. Proper inventory management ensures sufficient stock to meet demand without over-investing in unsold goods.
4. Accounts payable: Short-term obligations owed to suppliers and creditors for goods and services received. Managing accounts payable involves ensuring timely payments to maintain good supplier relationships while optimising cash flow.
5. Short-term debt: Includes loans and other financial obligations due within a year. Managing short-term debt is essential to ensure that the company can meet its obligations without compromising operational efficiency.

Effective management of these components ensures that a company can meet its short-term obligations and operate smoothly.

Formula to calculate working capital

Working capital is a key indicator of a company's short-term financial health and is calculated using the following formula:

Working capital = current assets – current liabilities

Where:

• Current assets: Assets that a company expects to convert into cash or use up within one year, such as cash and cash equivalents, accounts receivable, inventory, and other short-term assets.
• Current liabilities: Obligations that a company needs to settle within one year, including accounts payable, short-term debt, and other short-term liabilities.

For example, if a company has ₹5,00,000 in current assets and ₹3,00,000 in current liabilities, its working capital would be:

Working capital: ₹5,00,000 – ₹3,00,000 = ₹2,00,000

A positive working capital indicates that the company has sufficient short-term assets to cover its short-term liabilities, suggesting good financial health. Conversely, negative working capital may signal potential liquidity issues, indicating that the company might struggle to meet its short-term obligations. Regular monitoring of working capital is essential for businesses to ensure financial stability.

Positive vs. negative working capital

Positive working capital indicates that a company possesses ample liquid assets like cash and accounts receivable to offset its immediate financial responsibilities, such as accounts payable and short-term debts. This surplus liquidity boosts confidence in meeting obligations promptly and fuels operational stability. Conversely, negative working capital signals a deficiency in current assets to cover short-term financial commitments. Such a scenario poses challenges in honouring supplier payments and may hinder access to funding crucial for business expansion. Continual negative working capital could escalate into operational constraints, potentially leading to business closure if unresolved.
 

Sources of working capital

The sources for working capital can be long-term, short-term, or spontaneous. Long-term working capital sources include long-term loans, provision for depreciation, retained profits, debentures, and share capital. Short-term working capital sources include dividend or tax provisions, cash credit, public deposits, and others. Spontaneous working capital comes from trade credit, including notes payable and bills payable.
 

Types of working capital

There are several types of working capital based on the balance sheet or operating cycle view. A balance sheet view classifies working capital into two types of working capital:

• Net working capital: Net working capital is calculated by subtracting current liabilities from current assets, as shown on the balance sheet. This measure reflects a company’s ability to cover its short-term obligations using its short-term assets, indicating financial stability and operational efficiency.
• Gross working capital: Gross working capital refers to the total amount of current assets listed on the balance sheet. It includes cash, accounts receivable, and inventory, providing insight into a company’s available resources to support its day-to-day operations and growth.

The operating cycle view classifies working capital into temporary (difference between net working capital and permanent working capital) and permanent (fixed assets) working capital.
 

Working capital cycle

Working capital cycle refers to the time taken to convert net current liabilities and assets into cash by a business. The shorter the working capital cycle, the swifter the company will free up its blocked cash. Businesses strive to lower this working capital cycle to enhance liquidity in the short term. Bajaj Finserv offers working capital loans to address any deficits in working capital and ensure optimal operations.

Additional Read: Importance of capital budgeting
 

Advantages of working capital

There are several advantages to having adequate working capital, including:

• Improved cash flow management, which can help a business meet its financial obligations and avoid cash shortages.
• Ability to meet unexpected expenses, such as unexpected repairs or emergency purchases, without risking the financial stability of the company.
• Ability to take advantage of new business opportunities, such as expanding into new markets or investing in research and development.
• Increased market share and competitiveness, as a business that can meet customer demand consistently is more likely to succeed in its industry.
• Increased flexibility and resilience, as a business with adequate working capital can easily weather economic downturns or unexpected events.
   

Limitations of working capital

Working capital, while essential for day-to-day operations, has its limitations. One significant constraint is its cyclical nature, fluctuating with sales cycles and operational demands. Insufficient working capital can hinder business operations, leading to liquidity issues, missed opportunities, and strained supplier relationships. Additionally, over-reliance on short-term financing solutions to cover working capital needs may result in higher interest costs and financial risk. Furthermore, ineffective management of working capital can lead to inefficiencies, such as excessive inventory levels or extended accounts receivable periods, impacting profitability and cash flow in the long term. Thus, businesses must carefully manage working capital to mitigate these limitations and ensure sustainable growth.
 

Examples of working capital

An example of working capital includes the funds a retail store needs to purchase inventory for its shelves. Suppose a store requires Rs. 10,000 to buy stock for the upcoming holiday season. This Rs. 10,000 represents the working capital needed to ensure the store has enough goods to meet customer demand. As sales occur, the store can use revenue generated from these sales to replenish its working capital by purchasing more inventory. Working capital is crucial for maintaining smooth operations, ensuring adequate inventory levels, and meeting short-term financial obligations.
 

Why is working capital important?

Working capital is vital for businesses as it ensures smooth day-to-day operations by covering short-term financial obligations such as payroll, inventory purchases, and utility bills. Sufficient working capital allows businesses to seize growth opportunities, respond to unexpected expenses, and navigate economic downturns. It also enables businesses to maintain healthy cash flow, which is essential for meeting financial obligations and sustaining operations in the long term. Effective management of working capital enhances liquidity, reduces financial risk, and contributes to overall business stability and resilience in dynamic market environments.
 

What is negative working capital?

Negative working capital occurs when a company's short-term debts are more than their current assets. It means the company's liabilities exceed its ability to pay them, causing financial stress.

This affects businesses significantly, making it difficult for them to pay expenses, such as debts, salaries, or supplier invoices. It also indicates weak cash flow and poor financial management, thereby harming the company's credit score, increasing the risk of bankruptcy, and discouraging investors.

Negative working capital can result from slow-paying customers, excessive inventory, poor cash flow management, or insufficient sales. It may also be a deliberate financial strategy of delaying payments to vendors to conserve capital, which can lead to negative working capital.

Businesses can improve their working capital situation by negotiating payment terms with suppliers, managing inventory levels, facilitating favourable customer collections, and seeking alternative funding methods such as invoice financing or asset-based lending. Regular financial audits also help identify and rectify the underlying causes of negative working capital.
 

How can a company improve its working capital?

1. Optimise inventory management: Reduce excess inventory levels to free up cash and minimise storage costs.
2. Accelerate accounts receivable: Incentivise early payments from customers or implement stricter credit policies to shorten the accounts receivable period.
3. Extend accounts payable: Negotiate longer payment terms with suppliers to delay cash outflows and preserve working capital.
4. Streamline operational efficiency: Identify and eliminate inefficiencies in processes to reduce costs and improve cash flow.
5. Monitor cash flow: Regularly track cash flow forecasts and identify areas where cash is tied up unnecessarily.