Types of Working Capital
Working Capital is an essential requirement of business in today’s scenario. It is very tough for businesses to grow and flourish without enough working capital which is needed to meet their daily expenses. Businesses can only function well if they have enough working capital in hand. Shortage of working capital results in a shortage of raw materials and other resources which might hamper the success of any business. On the contrary, surplus working capital might result in a higher cost of production for the business.
Therefore, it is necessary to have neither surplus nor less but optimum working capital to successfully run a business. In other words, working capital should be almost exactly the actual amount required for running a business.
Furthermore, one should evaluate beforehand the returns on the funds that are invested in the form of working capital in the business. The return thus gained should not be less than the return earned by the business in other avenues.
Most of the time, businesses do not succeed not because of insufficient profits but because of lack of sufficient funds necessary to run its daily operations. Hence, management of working capital plays a crucial role in the success or failure of a business. That is because working capital immensely influences the profitability and liquidity of the business. So the first step for starting a business should be rightly ascertaining the actual working capital required and also the various avenues of financing such a working capital. This step is essential to ensure that the working capital in hand is sufficient enough to meet the obligations of the business in the short term. Therefore, one should properly understand the meaning of working capital and its importance in business and also the factors that influence the working capital of a specific business.
What is Working Capital?
Working capital may be defined as the money needed for financing current assets by aparticular firm. It symbolises the necessary funds available to the business to finance day-to-day operations, i.e. regular business activities, efficiently and effectively. It assists in calculating the operating liquidity of the specific company, i.e., how efficient the companyis in covering the short-term debt with the help of short-term assets.
Working Capital Formula
The term ‘working capital’ refers to the financial amount required by an enterprise to carry out regular business operations like rent of the premises where business is run, salaries of employees, raw materials, electric bill and other expenses that are necessary for the running of a business. This type of capital is not used for making investments or purchasing long-term assets. Instead, it is used to cover expenses related to short-term operations of the specific business. Typically, working capital amount is calculated on the basis of current liabilities and current assets in the form of a ratio called working capital ratio that is current assets divided by current liabilities. Thus, it is seen that every business needs working capital and the amount of capital can vary depending on the type of business.
So, it can be seen that working capital can also be called a calculator for measuring liquidity position of a business, its efficiency in operation, and soundness of finance in the short-term.
So the working capital can be understood through the following equation:
Working Capital is equal to the Current Assets minus the Current Liabilities
Now, let us understand what is the meaning of current assets and current liabilities of a business so as to understand the above mentioned equation.
Current Assets are those assets of the enterprise that can be easily cashed within twelve months or normal operating cycle of time of the business, whichever is greater. Generally these assets include:
- Cash and cash equivalents
- Prepaid Expenses
- Accounts Receivable
- Marketable Securities
- Current Liabilities
- Other Liquid Assets
Current Liabilities are defined as the obligations of the enterprise which are due within a year or one operating cycle, whichever is greater. These liabilities are paid by using either the current assets of the enterprise or by creating new current liabilities.
Current Liabilities include:
- Notes payable
- Accounts Payable
- Accrued Liabilities
- Current Portion of Long Term Debt
- Unearned Revenues
Working Capital Loans Benefits
There are lots of advantages of working capital loans and they are as follows:
- Lack of any restriction on how to use loan funds
- Easy availability of the working capital loan coupled with quick drawdown or disbursement
- Loans do not need any collateral and these are extended on the business credentials
- An affordable rate of interest and quite short tenure of loan as short as maybe 12 months
An enterprise can apply for business loans under various categories of working caplital loans depending on the needs of their business
Temporary Working Capital
Capital that is needed by the enterprise for some specific period of a year is termed as temporary working capital. For instance, this type of working capital might be the need of the hour during festive season due to the increases immediate demands of the business. This type of requirement is thus called temporary and so it changes depending on changes in the operations of the business and situations in the market. In short, this type of loan is taken for a short period temporarily to meet immediate demands and is paid back as soon as the cash starts coming in hand.
Permanent Working Capital
Capital that is needed to make liability payments even before the enterprise is able to change invoices or assets into cash is called the permanent working capital loan. This type of loan is needed by the business for a long and sometimes very long period of time. It also depends on the operating cycle. This type of loan is also known as hardcore working capital or fixed working capital, which is a requirement for the smooth functioning of any business.
Gross & Net Working Capital
Gross working capital, in actuality, is the company’s assets in total. Such assets are generally the ones which can be easily converted to cash in a year. These assets generally include:
- Receivable accounts
- Short-term investments
- Marketable securities such as stocks
The most preferred way of expressing the positive working capital is to define the ratio of the current assets to the current liabilities. Such a networking capital in the business is actually the difference in between the current liabilities and gross working capital.
Negative Working Capital
A deficit or shortfall is called negative working capital. This reflects that there is an excess of the current liabilities as compared to the current assets. Negative working capital increases if the current liabilities are exceeding the current assets. In simple terms, there is greater short-term debt as compared to short-term assets. In such a case of the working capital, it may be better as the company with some negative working capital funds would see a growth in its sales by borrowing more from the suppliers effectively and its customers. In the case of better management, the negative working capital might be a better way for funding the business growth through sales with someone else’s monetary funds.
Reserve Working Capital
The reserve working capital is another type of fund which the business needs to maintain above and over the working capital as required. Businesses need to use such types of funds in case of an emergency for some unexpected market opportunities or situations. So, the reserve working capital actually refers to a short-term financial need that is required by the businesses to cope up with uncertainties or meet any unexpected changes.
Regular Working Capital
Such type of working capital is generally the minimum capital which is required by business for running the daily operations. A business needs to maintain some kind of appropriate level of this regular working capital for operating with stability. This is the permanent working capital that is generally required for the general course of the business for ensuring a better flow of the working capital cycle.
So regular working capital can be defined as the least amount of money which is required by a certain business for carrying out the day to day operations of the business. One can consider paying the monthly payment of wages and salaries and maintaining some overhead expenditure for raw materials processing as required by the businesses. It is very essential for business to have a flow of regular working capital.
Seasonal Working Capital
Such a working capital generally refers to the higher amount of the working capital which is required by a business during its peak season in a particular year. Such businesses which somehow deal in the manufacturing or production of the products or if they provide some services which have some kind of seasonal demands are required in maintaining the seasonal working capital. This can be understood as a kind of reserve capital which is to adapt for the seasonal fluctuations or sudden change in the market of the business.
Seasonal working capital can be considered as the temporary increase in the working capital. It is not permanent. This is only applicable when businesses have some kind of impact on the seasons, such as a manufacturer of umbrellas and raincoats for them the monsoon is the relevant season. Generally, the working capital need will increase in the season for the higher demand and the sales in the monsoon period and then it will go down when the collection from debtors is greater than the sales. Let’s move to the last one.
Special Working Capital
This depends on the various types of working capital necessary, the company can choose to get additional finance as its working capital loan for maximizing such a business’s efficiency. This working capital is generally based on the urgent financial needs of the businesses. The extra working capital might also be needed by such a business for undertaking unforeseen circumstances or exceptional operations. Such capital which is required in crucial circumstances is known as the special working capital. There are funds that are required to finance marketing campaigns, or unforeseen events such as floods, accidental fires, etc. So, a special working capital loan is required due to the rise in the working capital temporarily due to the occurrence of a special event that didn’t take place generally. There is absolutely no chance to predict such a condition as such events take place rarely. For example in the Covid-19 scenario, there was a spike in the production of certain types of medicine, surgical masks and PPE kits. So, a pharmaceutical company manufacturing these would require special working capital for increasing the production of the medicines in the company. Also, such a scenario could not be predicted. Such short-term and special loans might help the company to boost its sales.
Types of Working Capital FAQs:
1. Is collateral required for a working capital loan?
2. What collateral would be acceptable for the loan facility?
3. Which companies are eligible?
4. Are traders eligible for this loan?
5. Is a sole proprietorship firm available for this loan?
6. Is a partnership firm available for this loan?
7. Can limited companies apply for loans?
8. What is the interest rate for this loan facility?
9. On what factors does interest rate depend?
10. What is the validity of the working finance limit?
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