In simple language working capital can be described as the funds required by an enterprise to finance its day-to-day operations. The working capital of a business is calculated by deducting current liabilities from current assets. Hence, an enterprise has a working capital surplus if its current assets are more than current liabilities. On the other hand, if the current assets are less than current liabilities, the business has a working capital deficiency. It is always important for small businesses to understand the importance of working capital in business, maintain working capital surplus to carry on business operations efficiently and meet short-term financial obligations timely. There are also a number of reasons why small businesses must explore ways to prevent working capital deficit.
Importance of Working Capital in Business: 7 Important Benefits
1) Depicts Financial Health of the Enterprise
While providing credit to small enterprises, lending institutions assess their financial health based on working capital ratio. The calculate working capital ratio by dividing the current assets by current liabilities. When the working capital ratio is less than one, the business has more current liabilities than current assets. The lack of additional current assets may even make it difficult for the enterprise to repay the debt on time.
2) Impacts Cash Flow Situation Directly
In addition to depicting its financial health, working capital also indicates the enterprise’s liquidity position. When the business has more current asset than current liabilities, it can meet its short-term financial needs and obligations by converting the current assets into cash. Hence, working capital deficit directly impacts a business’s cash flow situation, and makes it difficult for the enterprise to meet immediate financial needs. Here are a few tips to improve business cash flow.
3) Helps to Maintain a Good Credit History
Often small business owners find it difficult to avail credit on favourable terms. When the business has a good credit history, it becomes easier for entrepreneurs to meet strict credit requirements and negotiate for favourable interest rates. The entrepreneurs must repay both short-term and long-term debts on time to build a good credit history. They cannot repay debts on time if the working capital is negative.
4) Avail Cash Discount
Often sellers or suppliers of goods motivate business owners to make payment within a specific timeframe by allowing cash discounts. The small business owners must avail cash discount to reduce overall cost of inventory. But negative working capital often compels entrepreneurs to buy inventory on credit. Hence, the business owners cannot avail cash discount regularly without maintaining positive working capital.
5) Keep Employees Motivated and Productive
Many employees feel demotivated if the employer does not pay salaries and wages on time. The employees even start questioning the business’s financial stability and security when the entrepreneur does not make payroll on time. No entrepreneur can pay salaries and wages fully and timely without maintaining positive working capital. Also, positive working capital will help the business owners to keep employees motivated and boost their productivity.
6) Use Fixed Assets More Efficiently
Working capital is calculated by deducting current liabilities from current assets. But no enterprise can use its fixed assets like land and machinery due to working capital deficiency. Also, working capital deficiency will erode profits through depreciation in the value of fixed assets and interest on long-term debts. Hence, enterprises need to maintain a positive working capital to use their fixed assets efficiently and extensively.
7) Stay Prepared for Unforeseen Contingencies
The revenue and profits of an enterprise is impacted by both internal and external factors. There are always chances that the enterprise has to invest more funds to complete an operating cycle quickly and efficiently. Likewise, the small businesses also need additional working capital to carry on businesses during depression and compensate huge losses. When the business has surplus working capital it can easily address adverse economic conditions and unforeseen contingencies.
On the whole, no enterprise can remain profitable and sustain growth without maintaining working capital surplus. However, there are always chances that the enterprises have to avail credit to meet working capital needs. The enterprises can meet working capital finance needs through a variety of business loan products. But they can always consider availing credit from non-banking financial companies to avoid strict credit requirements and lengthy loan appraisal process.