How To Calculate Working Capital Requirement Of A Company?
To maintain profitability, a business owner must harness efficient working capital management strategy. Without sufficient working capital, a firm will not only incur losses but also find it challenging to continue its operations without interruptions. But how to determine your business's working capital requirement?
The best way to ascertain that is by understanding your firm’s working capital requirements.
What is Working Capital Requirement?
In simple words, working capital requirement can be described as the amount of money a firm would need to bridge the gap between its accounts payable and accounts receivable. It is essentially the amount a business requires to keep its operations afloat.
In the case of working capital deficit, businesses can use their outstanding invoices and avail funds to meet their working capital requirement. With KredX businesses can utilise their unpaid invoices to avail working capital within 24 -72 hours*.
Factors That Help To Determine Required Working Capital:
These are among the top factors that help businesses determine their working capital requirements -
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Factors
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Description
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Sales
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A significantly high sales volume generates high revenue which means the working capital required is not much.
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Duration of Operating Cycle
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The longer it takes a business to convert current assets into cash and cash equivalents, the more will be the required working capital.
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Type of Business
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Trading businesses require relatively high working capital when compared to manufacturing businesses.
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Terms of credit
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Businesses that extend longer terms of credit to customers are often in need of more working capital.
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Inventory turnover
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Stagnant or slow turnover of extensive inventories results in a higher working capital requirement.
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Seasonal variation
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Businesses that are dependent on specific seasons may need more working capital.
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Production technology
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Usually, labour-intensive businesses require more capital than a business which needs the use of machines.
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Contingencies
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A provision to meet the changes in demand and products’ price.
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How To Compute A Company’s Working Capital Requirement?
The formula for calculating working capital requirement is given by -
Working Capital formula = Current Assets - Current Liabilities
Here, current assets include these following -
- Cash in hand
- Cash equivalent
- Company inventory
- Accounts receivable
- Pre-paid liabilities
Here, current liabilities include these following -
- Accounts payable
- Notes payable
- Income tax owed
- Immediate debts
- Dividends
Based on this formula, businesses can estimate their working capital requirement easily. For instance, if the current assets of a firm exceed its current liabilities, it indicates that the firm has surplus working capital. Notably, items like cash commitments, non-trade receivable and old or wasted inventory are excluded or adjusted during the working capital requirement calculation.
Example of Working Capital Requirement Calculation:
Suppose the current assets of Mr Kumar’s business stands at Rs. 25000, while current liabilities amount to Rs. 45000.
Using the formula -
Working capital = Current assets - Current liabilities
= Rs. (25000 - 45000)
= - (Rs. 20000)
Since the outcome is negative, it indicates Mr Kumar’s business has a deficit in working capital. It means that his firm’s immediate liquidity is not enough to optimise everyday functions.
Some of the effective ways of reducing working capital gap include -
- Quick collection of accounts receivables
- Reducing inventory cycle
- Reducing credit terms
- Increasing sales volume
However, to meet your working capital requirement immediately and to keep operational activities continuous, you can opt for alternative solutions like invoice discounting services from KredX.
