Working Capital – Definition, Uses, Importance, Risks, and More
Working Capital Definition
Working capital is some financial resources that the company needs to continue operating and exploring its activity. It is incredibly relevant to the economic health and sustainability of the business.
These are the company’s financial resources in executing its products’ operating cycle, which will financially recover at the end of this cycle.
Therefore, it is what provides financial support to the company until its sales are received.
This article will understand the importance of working capital for a company and its different types. You will also learn how to calculate them through a didactic and straightforward explanation. Check it out.
What are the Uses of Working Capital?
- The resources used by a particular company to meet the commitments of its productive work make up the working capital.
- In this way, every society has different accounting accounts destined to favor or enable the supply of inputs to start its activity, allowing a company’s regular operation.
- The purchase of raw materials or the payment of wages at this point requires the ability to pay instantaneously utilizing money or other similar monetary instruments for short-term cost.
The Importance of Working Capital for Companies
- You have already unstated that working capital is the number of financial resources required to maintain a business.
- That definition is sufficient to show how essential it is to your business.
- It is crucial when company management wants to make an investment that will begin to generate returns at a future date.
- Therefore, it will cover existing expenses until the capital invested can be converted into income for the company.
- Working capital is also significant for provisions for sales or services paid in installments since amounts in this type of operation are received when maturity occurs. You may also need Lean project management software to eliminate wastes such as “excessive documentation, unnecessary planning and control, unproductive conferences, avoidable rework, the excessive definition of detailed necessities, unproductive multitasking,” and so on.
- Another critical use of working capital is related to customer default. When a business has this capital backing, it can cover sales made and not paid until the customer makes the settlement.
- Working capital is a tool that ensures the business’s operation, even when faced with periods of scarcity of resources to maintain its necessary expenditures.
- So, it is crucial that you, as a businessperson, know how to calculate and build essential working capital for your business.
What are the Risks of Working Capital?
- Even when they are aware of maintaining it, many entrepreneurs choose to ignore this step and not have control over these resources.
- In cases like these of inefficient management, the company is likely subject to conditions that could promote its financial performance.
- The business becomes vulnerable and at the mercy of the entry of money to continue its activities.
- Also, you end up using solutions such as loans and financing from banks and other institutions to pay the bills.
- The main problem in all this is that the company needs to bear these services’ costs, which are generally high and are accompanied by numerous fees.
- In the brief term, the company gets the money it wants. But in the long run, you take on significant debt that will continue to compromise your budget for a long time to come.
The Way to Control Working Capital
For those who are unwilling to face these problems and want to start organizing as soon as possible, we will teach you how to achieve it. Of course, the first step is to study working capital, as this will give you a deep understanding of the concept, the calculus, and its utility.
It would then help if you guaranteed favorable internal conditions to have a surplus of money to collect the working capital necessary to maintain the business.
To do this, you need to focus your attention on some crucial aspects:
- Delinquent customers;
- Adequacy of financial processes ;
- Long-term debt negotiation;
- Cash Flow;
- Financial cycle;
- Inventory management;
- It cost and expense reduction.
By taking care of each of these items and knowing what impact they have on your business budget, you can begin to focus on the amount needed for your business to maintain adequate working capital and ensure your financial health.
Difference Between Working Capital and Fixed Investment
- Contempt consuming different purposes and definitions, both working capital and fixed investment are necessary concepts for any company type’s proper functioning. However, many managers still confuse them.
- Fixed investment refers to the initial expenses necessary for a business to operate, encompassing all the required assets such as equipment and machinery.
- Therefore, when a company finds it, it must be estimated what fixed investment will be needed.
- It should be one of the first steps in business financial planning, even if the business already exists, all assets will document as it is with this projection.
- With this, it is possible to notice the main difference between the two concepts.
- The monetary amounts in cash, accounts payable and receivable, shares, or the current account, and the fixed investment are the assets.
- Therefore, although different, the two must be together in planning the financial management of your company.
What are the Types of Working Capital?
1. Net Working Capital
- Digging deeper into the topic, you will find the term: Net Working Capital (NWC). This concept mentions the amount you need to meet all of your short-term financial commitments.
- It is also known as networking capital. This concept uses as an indicator to manage and know all the business’s payment capabilities, which allows the management of relationships with suppliers and customers.
- It knows at each type of company needs resources (money) to maintain its fluidity activities and, consequently, to ensure that it remains active in the market.
- Therefore, the NWC can be considered a financial “slack” that allows the company and its shares to operate efficiently.
- Calculate it, and it is necessary to consider Current Assets (CA) and Current Liabilities (CL), which are concepts that working capital and net working capital have in common.
- The networking capital is the result of the amounts of current assets and current liabilities. So to calculate it, follow the formula: NWC = CA – CL.
- Current assets mention cash on hand, financial investments, accounts payable and receivable, stocks, expenses, raw resources, securities, bank deposits, bank transactions, and prepaid fees.
- Therefore, they are the properties and rights that can convert into cash in the short term.
- Current liabilities are all obligations that generally must pay within a year, such as bank loans, debts with suppliers, provisions, and individual accounts payable.
2. Own Working Capital
- Own working capital (OWC) define as the variable that indicates the company’s resources.
- Therefore, it will be contingent on the behavior of equity accounts and fixed assets.
- With this concept, the company’s equity that is completing the current and long-term assets will reveal.
- However, it should note that you will not strictly identify all the company’s resources.
- Although it seems a bit more complicated, own working capital can easily find with this formula: OWC = CA – CL – LTL.
- LTL or long-term obligations are the debts that your company must pay after the next financial year, which refers to a calendar year.
- Duplicates payable, taxes receivable, and other obligations with third parties consider.
- Finally, working capital is an essential indicator of your resources. With this, you will know the amount necessary for your business to operate and grow healthily and linearly.
The Elements of Working Capital
The calculation of working capital is quite simple; however, it requires some level of control of your company’s finances.
You will need some essential items of expenses and costs to determine your minimum working capital amount.
- Office and cleaning supplies;
- Miscellaneous expenditures such as water, telephone, internet, and insurance;
- Tax forecast;
- Expenses with ongoing services (accounting, legal advice, management software, etc.);
- Loan and financing terms in progress.
- In short, all the expenses and costs will happen regardless, and not your company receives payment in a given period. With this information, we will proceed to the next step: The calculation.
The Calculation of Working Capital
Once all the company’s expenses collect, it is time to calculate it, which is quite simple.
For example, we will create a hypothetical situation for a service provider company to determine the necessary working capital for a specific year.
From this, the following monthly expense amounts calculate:
- Electricity: $ 150.00;
- Rent: $ 500.00;
- Water, telephone and internet: $ 250.00;
- Payroll: $ 15,000.00;
- Office and cleaning supplies: $ 300.00;
- Tax forecast: $ 800.00;
- Expenses with ongoing services: $ 1,500.00.
Therefore, this company’s of it will want to remain active is $ 18,500.00 per month.
Some companies that receive recurring expenditures may include these amounts in their calculation to reduce expenses.
Suppose that the same company receives the amount of $ 5,000.00 each month from some customers. In that case, you can deduct the monthly payment estimate when calculating it. Therefore, the amount would be $ 13,500.00.
However, it is vital that this payment is recurring and guaranteed. You cannot consider this calculation the cost of generally delinquent clients.
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