What is Working Capital in Financial Management?

There is no doubt that working capital is the lifeblood of any business. It is integral for the well-being of a business while improving its efficiency. It is the key to managing your business effectively and making it smoothly functional. 

This is why a business needs efficient working capital in financial management that increases its cash flow to meet all its short-term obligations and fuel its growth. This becomes achievable by efficiently managing accounts receivable, accounts payables, inventory, cash, etc.

To know more about it, continue reading.

The working capital of an organization is computed by deducting its current liabilities from current assets. Working capital management refers to the techniques adopted by an organization to achieve its goals by properly using its assets and retaining a healthy cash flow.   

Now after knowing about working capital management, take a look at its importance in financial management. 

Working capital management is highly important regardless of the business you own. Having good working capital management leads to better profitability. Following are the significance of working capital management:

• Greater Return on Capital

Working capital of an organisation must not exceed the actual required amount. Higher working capital signifies a higher amount of assets funded via equity of the company’s owner. Higher use of equity indicates the higher amount of profits required to fetch the return on capital used. This can be burdensome for the business. Therefore, management of working capital becomes beneficial only when the owner’s equity is used to procure the needed number of assets.  This helps achieve higher return on invested capital.  

Also Read: What Are The Differences Between Shares and Stocks?

• More Liquidity

Having more working capital in a business reflects its greater liquidity and ability to clear outstanding dues on time. This way, it makes a business thrive even in tough situations and prevents it from losses or closing down and restores steady business operating levels.

• Appropriate Utilisation of Fixed Assets

Sufficient working capital and effective management enable a business entity to use its fixed assets, like machinery, computer equipment, vehicles, furniture, etc., more accurately. Sometimes, a business does not function properly since the working capital components like raw materials, and finished products are unavailable. Under such circumstances, the fixed assets of the business will stay idle, and its value will depreciate. 

• Improvement in Creditworthiness and Credit Profile

Precisely, the operating cycle of a business is said to be well-organised if it pays off its payments and unsettled dues timely. This way, maintaining the operating cycle accurately via proper working capital management in financial management boosts the credit score of the business entity. 

On the contrary, if a business fails while making repayments recurrently, it will cause a harsh impact on their credit score. Having a healthy credit score will enable a business to borrow credit facilities from financial institutions easily and vice versa. 

• Helps in Gaining Short-Term Profits

In some cases, business entities hold a lump sum amount of money much higher than the required amount as working capital. This way, after using the denoted working capital amount, the surplus funds are invested for a short tenure. Subsequently, this amount will create additional short-term profits for the entity in future. 

• Expansion of Business

Efficient working capital management of a business entity helps it to enlarge and flourish. Hence, if an entity wants to improve its productivity and business levels, they should maintain a steady working capital to execute it. A lack of substantial working capital will make it difficult for a business to run smoothly and develop its scale.

• Constant Trading and Production

Repaying your creditors timely is among the best ways to run your business. If the dues are not cleared on the dot, the vendors or creditors may postpone the delivery of raw materials. Since raw materials are an integral item of production and supply of products, delay in their arrival will hamper the entire production process as well as the business.

1. Gross Working Capital

The sum total of every current asset in a company is called gross working capital. It includes debtors, bills receivable, marketable securities, prepaid expenses, etc. This gross working capital of an enterprise is turned into cash before an accounting year.

The formula to compute gross working capital is stated below: 

Gross Working Capital = Sum total of all current assets

For example, suppose an organisation has current assets that include:

• Cash = ₹ 50000
• Debtors = ₹ 70000
• Inventory = ₹ 200000

Now, Gross Working Capital = Cash + Debtors + Inventory

= ₹ (50000 + 70000 + 200000)

= ₹ 320000 (gross working capital)

2. Net Working Capital

Net working capital signifies the excess of current assets over current liabilities. In other words, the difference between the current assets and current liabilities is termed the net working capital. 

The formula to calculate net working capital is stated below: 

Net Working Capital = Current Assets – Current Liabilities

For example, suppose an organisation has current assets comprising cash of ₹ 70000, debtors of ₹ 90000, and inventory of ₹ 60000 as well as current liabilities including bills payable ₹ 40000, creditors of ₹ 30,000, and outstanding expenses of ₹20,000

Now, Net Working Capital = ₹ (70000 + 90000 + 60000) – ₹ (40000 + 30000 + 20000)

= ₹ 220000 – 90000

= ₹ 130000 (net working capital)

After going through the formula to calculate working capital in financial management as well as the importance of working capital management, take a look at the factors that influence it.

Apart from the functions of working capital management in financial management, there are some factors responsible for influencing the working capital: 

• Type of Business

The primary factor that influences the need for working capital is the nature of a business. Put simply, if you are involved in a retail business or trading company, you will require less amount of working capital because the cycle of your business operation is small. On the contrary, a wholesale house will require a higher amount of working capital since they are required to maintain a huge stock and their cycle of operation is lengthy. 

• Variation in Business Cycle 

The business cycle involving boom and recession in the marketplace is a natural phenomenon. During growth, a business, regardless of its size, will require a higher amount of working capital due to increased market demand, having more inventories, and producing more. Conversely, a depression phase typically leads to less demand, less need for inventory, less production, and, thereby, less working capital.  

• Seasonal Variations 

A business that has a demand for goods throughout the year will require a non-stop flow of working capital. On the contrary, businesses that are selling seasonal products will be in need of substantial working capital during the peak season to meet the huge market demand and maintain more stock so that the supplies can be made fast. However, they will require very less capital during the off-season due to the decline in demand.   

• Production Cycle

A company involved in a labour-intensive large-scale production cycle will require more working capital to maintain sufficient cash flow for labour payment. However, a business involved in capital-oriented ventures needs less working capital as this type of business invests in machinery as a fixed capital and has less operating cost.  

• Operational Efficiency

Operating cycle of any business is determined from its time of procurement of raw materials to credit realisation. The duration of its operating cycle directly impacts the need for its working capital. For instance, a company with greater operating efficiency requires less working capital compared to a company with low operating efficiency. 

• Credit Policy

The average cycle of collection against sales proceeds is called the credit policy of a company. Based on the factors such as industry norms and the creditworthiness of clients, a company can have a liberal or strict credit policy. 

So, a business having a flexible credit policy will be in need of an enhanced amount of working capital since it allows an extended period for its creditors to pay. Conversely, a company that follows a strict credit policy will need less amount of working capital.

• Availing Credit 

Similarly, the period of credit a company is allowed from the supplies also influences its need for working capital. Therefore, a company that gets a long period of credit from the market needs less amount of working capital as opposed to a company that enjoys short-term credit benefits.

• Raw Material Availability 

The availability of raw materials is another factor that affects the requirement for working capital. A firm that has easy access to raw materials in the marketplace does not need to keep much stock and thus needs less working capital. However, if materials are not easily available, a business needs to maintain enough inventories, which will require more working capital.

• Inflation

Inflation typically increases the cost of raw materials, labour etc., and consequently increases the need for working capital. However, a business that can also increase the cost of its product can manage with its working capital. Precisely, inflation affects the requirement of working capital but varies among businesses. 

• Level of Competition

If you are involved in a business wherein competition is intense, then you will have to follow a flexible credit policy to sustain in the market. In that case, you will have to maintain higher stock which will increase the need for your working capital. However, in a market with less competition or one where you enjoy a monopolistic position, you can command your own terms, which will lessen the requirement of your working capital.   

• Growth Prospects

The growth prospect of a business also influences the need for working capital. A company that is expanding or planning to flourish its business activity will be in need of more working capital. This is required for enhancing its production level, which results in the need for more raw materials, labour, and other inputs.  

Now the concept of working capital management in financial management should be crystal-clear to you. Besides, you also know its importance in business. Therefore, make sure to manage your working capital efficiently to avail its benefits. Also, have a glance at the factors that affect working capital requirement.

Also Read: Inflation: Meaning, Working, Calculation.