Working Capital

Working capital may be regarded as the life blood of business. Working capital is of major importance to internal and external analysis because of its close relationship with the current day-to-day operations of a business. Every business needs funds for two purposes.

* Long term  funds are required  to create production facilities through purchase of fixed assets such as plants, machineries, lands, buildings & etc

* Short term funds are required for the purchase of raw materials, payment of wages, and other day-to-day expenses. . It is other wise known as revolving or circulating capital

It is nothing but the difference between current assets and current liabilities. i.e. Working Capital = Current Asset – Current Liability.

Businesses use capital for construction, renovation, furniture, software, equipment, or machinery. It is also commonly used to purchase inventory, or to make payroll. Capital is also used often by businesses to put a down payment down on a piece of commercial real estate. Working capital is essential for any business to succeed. It is becoming increasingly important to have access to more working capital when we need it.

Importance of Adequate Working Capital

A business firm must maintain an adequate level of working capital in order to run its business smoothly. It is worthy to note that both excessive and inadequate working capital positions are harmful. Working capital is just like the heart of business. If it becomes weak, the business can hardly prosper and survive. No business can run successfully without an adequate amount of working capital.

Danger of inadequate working capital

When working capital is inadequate, a firm faces the following problems.

Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount.

Concept of working capital

<!–[if !supportLists]–>1)    <!–[endif]–>Gross Working Capital = Total of Current Asset

<!–[if !supportLists]–>2)    <!–[endif]–>Net Working Capital = Excess of Current Asset over Current Liability

<!–[if !supportLists]–>3)    <!–[endif]–>Negative Working Capital=Excess of Current liabilities over Current Assets

Current Assets
Current Liabilities
Cash in hand / at bank
Bills Receivable
Sundry Debtors
Short term loans
Investors/ stock
Temporary investment
Prepaid expenses
Accrued incomes
Bills Payable
Sundry Creditors
Outstanding expenses
Accrued expenses
Bank Over draft

One of the most important areas of finance to monitor is your company’s working capital, which is the difference between current assets and current liabilities. As a small business owner, you must constantly be alert to changes in working capital and their implications; otherwise, you may miss some warning signs that can lead to business failure. The most important component of working capital is cash, far the most important asset of any business, particularly a small business. Without it, the business will fail. So it is of paramount importance for you as the business owner to control all cash transactions.

It is helpful for us, as a business owner, to think of working capital in terms of five components:

1. Cash and equivalents
. This most liquid form of working capital requires constant supervision. A good cash budgeting and forecasting system provides answers to key questions such as: Is the cash level adequate to meet current expenses as they come due? What is the timing relationship between cash inflow and outflow? When will peak cash needs occur? When and how much bank borrowing will be needed to meet any cash shortfalls? When will repayment be expected and will the cash flow cover it?

2. Accounts receivable. Many businesses extend credit to their customers. If you do, is the amount of accounts receivable reasonable relative to sales? How rapidly are receivables being collected? Which customers are slow to pay and what should be done about them?

3. Inventory. Inventory is often as much as 50 percent of a firm’s current assets, so naturally it requires continual scrutiny. Is the inventory level reasonable compared with sales and the nature of your business? What’s the rate of inventory turnover compared with other companies in your type of business?

4. Accounts payable. Financing by suppliers is common in small business; it is one of the major sources of funds for entrepreneurs. Is the amount of money owed suppliers reasonable relative to what you purchase? What is your firm’s payment policy doing to enhance or detract from your credit rating?

5. Accrued expenses and taxes payable. These are obligations of your company at any given time and represent a future outflow of cash.