The revenue or fund that your business has to run the daily, weekly and monthly operations is called the working capital. This includes maintenance costs, rent, office materials and utilities.
The absence of a working capital causes a business to fail; hence it has an intricate relationship with the health of business.
Working capital is also scrutinised by investors to assess your company’s financial well-being. It also identifies the liquidity of the business, i.e., the ease with which the company’s assets can be sold to convert to cash.
Calculating Working Capital
Working capital for businesses can be found through a simple formula,
Working Capital = Current Assets – Current Liabilities
The amount of working capital of your business indicates your capability to pay off short-term debts and expenses on a daily basis. The higher the working capital, the healthier your business is. If your working capital is on the lower side, then you should reassess your commercial model and business strategy.
Working capital can also be found using a ratio,
Working Capital Ratio = Current Assets / Current Liabilities
If the working capital ratio you calculated is less than 1, then your liabilities exceed your assets. This negative working capital is a sign of an unhealthy business. However, if this ratio is a very high number, then your business has too much inventory or assets on hand. Some of these assets can be invested on a long-term basis to help the company grow.
The ideal working capital ratio varies based on the industry that your business services. But, if this value is on an average between 1.2 and 2.0, then your business is running on a healthy note.
Purpose of Working Capital Management
The principal objectives of working capital management are,
- Ensuring the smooth operation of the working capital operating cycle
The operating cycle here is the business lifecycle in its entirety. This includes the acquisition of raw materials, smooth production processes and delivery of products. One of the main objectives of the concept is to ensure smoothness in end-to-end processes.
- Reducing cost of capital
The amount that is spent on maintaining the working capital is called cost of capital. These costs need to be carefully monitored and managed.
- Maximising returns on asset investments
The ROI on assets that are currently invested should be greater than the weighted average cost of capital to ensure that wealth is maximised.
Working Capital Management – Approaches
There are three strategies that are commonly employed for the management of working capital.
- The Conservative Approach
As per this approach, in addition to the everlasting working capital, the variable working capital is also funded from long-term sources. This implies an increase in cost capital, but the risk of fluctuations in interest rates are lower.
- The Aggressive Approach
In this strategy, the variable working capital, the whole or parts of the permanent working capital and, at times, the fixed assets are financed from short-term sources. The cost capital is hence decreased, resulting in maximum profits, but it holds significantly higher risks.
- The Hedging Approach
The fixed assets and the stable working capital are funded from long-term resources, while the variable working capital is supplied from short-term sources. This ensures moderate risks and moderate profitability.
Importance of Working Capital to a Business
- Businesses with a lower working capital will enable shareholders to benefit from a higher return on every dollar invested.
- Appropriate working capital management will allow businesses to pay their short-term obligations on time and improve their credit profile and solvency.
- Working capital management drives the profitability of small businesses.
- Good working capital management allows businesses to allocate resources efficiently and improve liquidity.
- It also results in higher business valuation and favourable financing conditions.
- Businesses with good working capital management can ensure uninterrupted production and will be immune to peak demands. Studies have shown that they have a distinct competitive advantage in the industry.
LSI Keywords: Working Capital, Current Assets, Current Liabilities, Working Capital Management, Importance of Working Capital, returns on asset investments, working capital operating cycle
References
http://www.investopedia.com/ask/answers/100715/why-working-capital-management-important-company.asp
http://accountlearning.blogspot.in/2011/06/need-and-importance-of-working-capital.html
https://www.linkedin.com/pulse/importance-good-working-capital-management-business-fareed
https://www.kashoo.com/blog/what-is-working-capital-and-why-is-it-important
https://www.paychex.com/articles/finance/why-is-working-capital-important-for-business-success
http://smallbusiness.chron.com/importance-working-capital-management-avoiding-bankruptcy-39031.html
https://www.cleverism.com/working-capital-management-everything-need-know/
http://www.yourarticlelibrary.com/finance/importance-of-sufficient-working-capital/26225/
