Working capital is one of the most crucial components for ensuring a smooth operation of any business. It is regarded as a useful financial tool that gives a fair idea about a business’ short-term financial standing. Thus, businesses facing working capital deficits must take immediate measures to address the same.
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Typically, it is described as the difference between a business’s current assets and current liabilities. The ratio obtained, further helps to estimate whether a company is capable enough to meet its short-term debts or not.
In other words, it is the sum of money that is available with a firm to keep its daily functions running smoothly. Working capital represents a company’s operational activities and includes –
Its formula is –
Working capital = Current Assets – Current Liabilities
Its role in determining a firm’s financial standing makes working capital a vital factor for both business owners and financial analysts. Notably, a sharp increase in working capital is often responsible for increasing the cost of a business. Conversely, inadequate working capital is among the primary reasons for the shortage of resources.
Depending on the periodicity, working capital in India can be divided into these following types -
This particular type is also known as a fixed working capital. Permanent working capital consists of the minimum current assets required to keep business operations afloat. It must be noted here that the size of fixed working capital depends on production scale and growth. Mostly, long-term funding sources are utilised for availing fixed working capital.
Variable or fluctuating working capital is essentially the amount that is invested in a business venture for a short period. It can also be described as an additional working capital that is used to account for the changes in production and sales activities. Variable working capital in India is also known as temporary working capital.
This particular working capital consists of the short-term financial arrangement that business entities make to account for unforeseen expenses. It is also known as “cushion working capital” as it helps to mitigate unwarranted business-oriented risks, allowing entities to sustain during a crisis.
Typically, a business requires more working capital to meet customer demands during peak seasons. In such cases, business owners often opt for additional financial assistance. The working capital, thus secured in due course, is classified as – seasonal working capital in India.
Mostly, this particular type can be described as the minimum working capital that has to be maintained by a firm under normal circumstances.
This particular type can be best described as the additional working capital that a business requires for meeting unique circumstances. The special variable working capital can be channelled - to fund the launch of new products, finance marketing campaigns, and for risk management, among others.
It is essentially the fund invested under a firm’s current assets and thus serves as a potent indicator of the same. Some of the major components of gross working capital are as follows
It is undoubtedly an essential type of working capital. Networking capital signifies the amount by which a firm’s current assets surpass its current liabilities. In simple words, it is the difference between a business firm’s total current assets and current liabilities.
Working capital life cycle denotes the length of time a business firm takes to convert their aggregate net working capital into cash. Also, it indicates the proficiency and capability of an organisation to manage its liquidity in the short-run. In other words, it is the time between purchasing raw materials and generating revenue by selling manufactured goods.
Following are a few crucial highlights pertaining to the life cycle of working capital–
It must be noted here that this entire cycle is deemed complete, only when the firm has received cash for the products sold. It is also expressed as–
Working capital life cycle = Inventory days + Receivable days – Payable days
Notably, the shorter this cycle, the better a company is positioned to free up the cash caught in its working capital. It is vital to maintain a shorter cycle; otherwise, capital will end up being locked in the operational cycle without generating any returns.
An effective way to shorten this life cycle is by increasing proficiency of the business venture and enhancing its liquidity in the short-term. Typically, a business maintains this by selling inventory, generating earnings through sales and gradually paying off existing debts.
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Working capital is an essential component of every business irrespective of its size and scale of operation. Some benefits of working capital include –
Negative working capital is detrimental for the image of a company as it reflects that a firm is incapable of paying off its short-term debts. In turn, it erodes the firm’s chance of availing financial assistance to replenish the required existing working capital.
Under such circumstances, firm owners may opt for alternative funding options like – invoice discounting. This is a type of invoice financing facility which helps business owners to avail capital by leveraging their firm’s sales ledgers.
To elaborate, through invoice discounting business owners can sell their invoices or accounts receivable to lenders at a discounted rate, usually 70-90% of the original value. The value, thus availed can be readily used to fulfil the business’ working capital requirements. Firm owners can use the value thus availed to continue their operational activities, expand the scale of business or replenish their inventory, among other things.
It must be noted that the value of invoice discounting depends on factors including the borrower’s creditworthiness, the due date of invoice, etc. Usually, an invoice that is due in 15 days will be relatively cheaper than the one due in 60 days.
KredX provides such working capital solutions in the form of zero-liability bill discounting across several industries. Our transparent policies and paperless procedure help businesses meet working capital requirements effortlessly.
It is a fact that the different sections of a company's financial statement tend to influence one another. One of the best examples of this is the impact of change in working capital on cash flow.
For instance, an increase in a firm's current assets and current liabilities by the same units will not lead to any change in its working capital.
These examples below offer a better idea about the impact -
Since cash flow and working capital are close-knit, it is essential to adopt effective cash flow management strategies and practise working capital management. Doing so, firms will be able to optimise and maintain both successfully.
There are a few primary components that give working capital a shape, which include –
Inventory is a vital component of a firm's current assets, and as a result, crucial for efficient management of working capital. Ideally, raw materials, semi-finished, and finished goods make up the inventory or stock.
Accounts receivables or trade receivables denote the unpaid bills that a company raises in the event of selling and delivering goods on credit.
Accounts payable or trade payables make up a vital part of current liabilities. Generally, accounts payable signify the amount that a firm has to pay against the credit purchases they made. Experts recommend businesses to adopt well-rounded management strategies to ensure timely payments and a smooth cash flow.
Undoubtedly one of the most essential components of working capital is current assets, to be specific, as it helps to maintain and optimise operating activities. One must note that cash also includes liquid securities that can be easily converted. It is important to manage cash efficiently to optimise the operating cycle, cut unwanted expenses, and boost profitability.