Working Capital: Importance, benefits & how to calculate it using a formula
Working capital refers to measuring an organization’s liquidity, which is required to manage its daily operations. Regardless of their structure or size, all the companies need working capital finance, given that maximum of their transactions generally happen through credit. The credit period can extend anywhere from a few weeks to months. As an outcome, companies may not have adequate liquidity to meet their short-term obligations. Here, a working capital loan can come in handy for meeting the cash flow shortfalls of a company.
How is working capital calculated?
The working capital requirement can be calculated by deducting current liabilities from the existing assets owned by the company. Major constituents of a company’s existing assets include cash in hand, inventory or stock, and account receivables while components of a company’s current liabilities include wages, payables, taxes, and the interest owed.
Working capital formula
Working capital (WC) = current assets (CA) – current liabilities (CL)
With an example, let us understand the need to calculate the working capital requirement
Total existing assets of business X were valued at Rs 45,000, while its total current liabilities summed to Rs 65,000. The WC of business X would be CA – CL (45,000 – 65,000), i.e., a deficit of Rs 20,000.
Remember that an excess of CA over CL leads to WC surplus. Contrarily, much CL over CA equates to a WC deficit (as calculated in the above example). WC deficit indicates that the short-term liquidity of the company is not at an optimum level, which means the business needs additional working capital finance to meet its regular operations. This capital funding can be availed through a working capital loan.
Note that there are five common working capital types of credit, and businesses can avail of any of them depending upon their preference and requirement. Working capital types of credit include cash credit, overdraft facility, bill discounting, letter of credit, and bank guarantee.
Working capital importance
Working capital is utilized to finance operations and mitigate short-term obligations. If a company has adequate working capital, it can continue paying its suppliers, staff/employees and meet its other crucial obligations like paying debts and taxes. However, if the company has no working capital, it may opt for loans to avail of working capital finance. Working capital loans may be available to those companies with a good credit score having an operational period of at least 2-3 years and a stable and credible financial history of profits. Once the company avails the proceeds through a loan, they have 2-fold responsibilities, firstly, to work with their finance team to maintain adequate working capital to cover up all their liabilities, and secondly, to focus on maintaining sufficient emergency funds for the future monetary mismatches.
Benefits of working capital
Working capital can bring about smoothness in revenue fluctuations. For instance, in the case of season-based businesses, the products or services sell more during specific months than the remaining months. With sufficient working capital, such companies can make additional purchases from their suppliers to be well prepared for the busy months of sale while meeting their financial obligations in those periods when they get less revenue.
Thus, working capital brings about flexibility, allows the company to satisfy their customers’ orders, invest in new services and products, and expand their business. Also, it acts as a cushion for the industry when it needs extra money.
Working capital is the critical indicator of business health, determined by subtracting current liabilities from current assets. This figure reflects the company’s capital to meet their day to day operational expenses. In simpler words, working capital can ascertain whether a company can fulfill all its short-term obligations like debts, salaries, supplier invoices, etc. If a company fails to hold the required working capital, it can choose to avail of a working capital loan. A working capital loan can help bridge the financial gap between customer orders and supplier payments. Also, it can help them meet various other crucial short-term financial obligations.