Synopsis: In today’s blog, we will touch upon the importance of working capital as a critical resource for your business and how you can boost your working capital to secure better financial health for your business. 

Every business requires an adequate amount of capital to ensure the smooth running of its operations. Funds are required for paying salaries to your employees, meeting your daily expenses, and for planning your payables cycle. This capital requirement is known as working capital. It serves as the nerve center and lifeblood of a business. 

But why is working capital so pivotal to the success of a business? Why do businesses need to project their working capital requirements and consider ways to generate enough cash? Let’s understand in detail. 

What is Working Capital?

Working capital represents a part of total capital that is utilized for meeting the regular day-to-day expenses of a business. It is a measure of a company’s liquidity and short-term financial health. As a financial metric, it refers to the difference between a company’s current assets and current liabilities, as recorded on its balance sheet. 
 
A positive working capital ensures that a business is capable of funding its operations. It is also suggestive of a business’s potential to save and invest for future growth opportunities. However, a high amount of working capital isn’t necessarily a good thing. This is because it could be indicative of an excessive buildup of inventory in the business, or a lack of capitalization on low-expense debt opportunities. 

In contrast, a business with negative working capital may face trouble in paying off its suppliers and creditors. It may even be forced to shut down. In such scenarios, businesses can opt for loan like working capital loans and work on improving their business operations.

How is Working Capital Calculated? 

As mentioned above, working capital represents the difference between a company’s current assets and current liabilities.  

To illustrate, say, a company has Rs. 10 lakh worth of current assets and Rs. 3 lakh as current liabilities. In such a case, working capital is calculated as follows. 

Working Capital = Current Assets – Current Liabilities 
Working Capital = Rs. (10,00,000 – 3,00,000) 
Working Capital = Rs. 7,00,000 

This means the company has Rs. 7 lakh at its disposal to meet its short-term obligations as well as to meet any contingencies. But what exactly constitutes current assets and current liabilities? Let’s elaborate a little more. 

Components of Working Capital 

Current assets are those assets that can be converted into cash within a year. Examples include cash and cash equivalents, inventory, accounts receivable, prepaid expenses, and short-term investments.  

Current liabilities, on the other hand, refer to liabilities that need to be paid within a year. Accounts payable, accrued expenses, deferred revenue, and short-term debt are some examples of current liabilities. 

Is Working Capital Different from Net Working Capital? 

Generally, working capital and net working capital are considered synonymous in nature. However, some analysts may differentiate between the two. As a result, the working capital formula changes into the following form. 

Net Working Capital = Current Assets (excluding cash) – Current Liabilities (excluding debt) 

Or 

Net Working Capital = Accounts Receivable + Inventory – Accounts Payable 

This net working capital formula may be preferred by some as it is more reflective of a business’s daily operations. 

What is the Ideal Amount of Working Capital? 

Usually, a working capital ratio, also known as the current ratio, is employed by businesses to better gauge their optimal amount of working capital. It is calculated as a ratio of current assets to current liabilities. A ratio below 1 would indicate negative working capital, whereas a ratio above 2 would indicate excess assets. 

The ideal amount of working capital for a company would typically differ by industry. For instance, manufacturers with longer production cycles, where inventory cannot be converted into cash fast enough, will have higher working capital needs. On the other hand, retail businesses can make do with lower working capital as they can raise short-term funds much more quickly. 

A business can also tolerate a lower ratio if it carries more cash versus inventory. This usually happens for e-commerce companies that have consistent sales and where customers prepay with credit cards when placing orders. In contrast, companies with over 60-day payment terms will need more working capital.

Why is Working Capital Important? 

Successfully meeting your business’s working capital requirements not only ensures its sustenance but also creates the potential for further growth. As a business owner, you must undertake the practice of working capital management to optimize the utilization of working capital. This will enable you to reap the benefits enlisted below: 

• Finance your day-to-day operational needs, including paying your employees and vendors. 
• Build credibility with suppliers as you can pay on time. 
• Improve the creditworthiness of your business which helps in availing of business loans at lower interest rates. 
• Weather unfavorable events, when the sales are slow, or when there is a sudden cash outflow. 
• Reinvest the cash into the business to capitalize on growth opportunities. 

Why You May Need More Working Capital?

Despite your best efforts, there may be instances where your business may need more working capital. For example, when a supplier offers high volume discounts, that can result in substantial cost savings for the business. Another instance would be when customers demand long payment terms, thus impacting your working capital cycle negatively and increasing requirements for working capital. 

A business may also need more working capital if it is seasonal in nature. This is because working capital needs will increase manifold during the peak selling season. Finally, a business undergoing rapid growth will need a substantial boost in working capital as requirements for inventory and accounts receivable will go up. Extra working capital may also be needed to fund special projects targeted at the business expansion. 

Finding Ways to Boost Your Working Capital 

The typical ways of improving your working capital include renegotiating your terms with suppliers and customers to ensure better cash management. Another possibility is to reduce your inventory levels to minimize losses from maintaining obsolete inventory. 

You can also augment your working capital by applying for a working capital loan. It is specifically designed to address temporary operational needs. A working capital loan is usually structured as a revolving line of credit, where the borrower has the option to draw funds as and when required. However, many lenders may limit the loan sanction to 10% of your business’s sales. 

Apply at Protium to Avail of a Working Capital Loan 

Are you a business owner looking for a working capital loan at attractive interest rates with minimal documentation? Apply at Protium for instant approval or call us at 8828827800 to get in touch with our representative!