The capital required by a business can be divided into two broad categories – fixed capital and working capital. Fixed capital refers to the amount invested in long-term assets. This category of capital is not consumed during the production process. Many entrepreneurs ask us what is working capital. Working capital refers to the amount invested in current assets. Also, working capital can be defined as the Investment required by an enterprise to fund its day-to-day operations. Hence, working capital is calculated by deducting current liabilities from current assets.
Formula for Calculating Working Capital
One can calculate working capital of an enterprise with this formula.
Working Capital = Current Assets – Current Liabilities
Current assets include the assets that can convert into cash quickly. Hence, current assets include cash in hand, cash at bank, bills receivables, and inventory. At the same time, current liabilities refer to the debts the business needs to repay within the same accounting year. Hence, one can calculate the working capital by deducting the short-term debts of the business from its short-term assets.
Importance of Working Capital
While processing credit requests, lending institutions assess the business’s financial health based on its working capital. They consider the business to be healthy if its current assets exceed current liabilities by a huge margin. On the other hand, if the current liabilities exceed current assets, the business is considered to be in critical stage. The business owners have to infuse additional funds to meet concurrent working capital needs and sustain growth. It is always important for the entrepreneur to maintain positive working capital to discharge current liabilities on time and maintain positive cash flow position.
Working Capital Ratio
A business can assess its financial health precisely based on working capital ratio. It can calculate working capital ratio by applying this simple formula.
Working Capital Ratio = Current Assets/Current Liabilities
If the working capital ratio is below 1, the business has a negative working capital. It must arrange funds immediately to repay short-term debts on time and maintain a positive cash flow position. On the other hand, the business has more than required funds, if the working capital ratio is above 2. It must explore ways to reinvest the surplus working capital efficiently to get higher returns. However, the business must focus on maintaining positive cash flow if the working capital ratio ranges from 1.2 to 2.
Fluctuations in Working Capital Requirements
The working capital requirements differ from one enterprise to another. Some enterprises need to maintain positive working capital throughout the year to stay profitable and beat competition. At the same time, the businesses which are seasonal or cyclical need additional working capital during peak business period. For instance, a business dealing in costumes and apparels have to improve working capital ratio during festive seasons to meet growing demand and deliver optimal customer experience. Hence, the smart entrepreneurs monitor working capital consistently and meet working capital needs by choosing the right loan products.
Funding Options to Meet Working Capital Needs
The business owners can meet working capital needs through both internal and external funding options. For instance, they can infuse working capital by investing their personal funds. The small business owners can even meet working capital needs by borrowing money from their friends/relatives at low interest rates. However, they cannot opt for bootstrapping if the working capital needs are high.
The entrepreneurs can meet working capital need by availing working capital loans from nationalized/private banks, non banking financial companies, peer-to-peer lending platforms, and fintech companies. They even have option to choose from a wide range of conventional and technology-driven business loan products. But many enterprises find it more convenient to meet working capital needs through technology-driven loan products.
The technology-driven loan products even help business owners to avoid strict credit requirements and lengthy approval process. Some of these modern loan products even enable business owners to avail credit based on their monthly turnover or unpaid invoices. At the same time, the entrepreneurs can even repay the non-conventional debts more flexibly by choosing from multiple repayment options.
On the whole, working capital refers to the funds required by a business to carry out its day-to-day operations smoothly. One can calculate the working capital of a business by deducting its current liabilities from its current assets. Also, an enterprise can assess its current financial position by calculating working capital ratio. However, it is always important for the enterprise to maintain a positive working capital to sustain growth and remain profitable in the long run.