It is necessary to have adequate capital for the smooth functioning of a business. Capital is required to conduct daily business operations, which includes maintaining inventory, accounts payable and accounts receivables. This capital is known as working capital.
About Working Capital
Working capital is a financial metric used to measure the company’s efficiency, liquidity, and stability. It evaluates the firm’s ability to meet its short-term obligations. In accounting terms, working capital is defined as net liquid assets, which is computed by deducting the firm’s current liabilities from current assets. Firms which do not have sufficient working capital often obtain the necessary funds by availing of a business loan. Such finance, obtained either from a bank or a Non-Banking Financial Company, helps to meet the necessary working capital requirements of the firm.
Method to Calculate the Business’ Working Capital Needs
One of the common methods of determining the business’ working capital needs is by calculating the current assets over current liabilities. Current assets are the assets which the business may convert into cash within a year. Examples of current assets include savings and checking accounts, stocks and bonds, and inventory. Current liabilities, on the other hand, include expenses such as the cost of materials and supplies, payments for rent, electricity, water, interest, and tax. The working capital is therefore calculated by deducting these current liabilities from the current assets. However, this formula does not provide an in-depth understanding of what the firm’s working capital needs are and how to meet them.
A more useful method of determining the working capital needs of a business is analyzing the firm’s operating cycle. The operating cycle of a business consists of three components, namely inventory, accounts receivables, and accounts payable. Inventory is calculated by the average number of days taken to turn over the sale of a product. Accounts receivables are calculated by the average number of days taken to collect an account. Accounts payable, on the other hand, is analyzed by the average days taken to pay a supplier the invoice.
Sometimes it becomes difficult to finance inventory and accounts payable with the funds generated from accounts receivable alone. During such times, it is necessary to obtain additional working capital. This shortfall is usually met through a business loan.
Factors to Consider while Analyzing the Business’ Working Capital Needs
In order to calculate the working capital needs of a business, it is important to consider the industry the firm is operating in. Firms that have a higher physical inventory need a greater amount of working capital to run the firm smoothly. On the other hand, firms that provide consulting or other such services require lower working capital. The rate of growth of the business also has an impact on its working capital needs. If the firm is newly-established and looking to expand, higher working capital is required.
In order to function smoothly, it is important that the firm has the capacity to pay off its current liabilities with its current assets. Therefore, determining the working capital needs is important. Businesses should have a good understanding of their working capital needs to make the venture successful.