As an entrepreneur, you need to maintain a certain amount of assets to meet the daily expenditure of your startup. And here, the role of Working Capital is very crucial. However, startups often forget to manage it and run out of money at some point in time.
Understanding Working Capital Management and the factors influencing it will not just save you from insolvency but also help you run your business smoothly.
First, let me clear you that it isn’t a buzz word or jargon you usually find on the internet. Then what’s it? Let’s decrypt it.
What is Working Capital
Working capital, also known as Net Working Capital (NWC), is the difference between a company’s current assets and its current liabilities. Current assets would include cash, accounts receivable (customers’ unpaid bills), and inventories of raw materials and finished goods. Current liabilities will be accounts payable.
Don’t get puzzled. Let’s clear the concept with an example.
Suppose you start a sports shop with an investment of 10 Lakhs. You invest 80% of the capital in setting up shop, i.e., your business’s fixed assets. Now it’s time to procure inventories. You contact a sports goods manufacturer and make an order of 1.5 lakh. Instead of paying 1.5 lakh, you paid only 1 lakh to the manufacturer.
You also have to pay the monthly rent of a shop that is 20 thousand.
Now let’s look at your balance sheet
1. Fixed assets – 8 lakh
2. Current assets – 1.5 lakh (current inventory) + 1 lakh (money left in your account)
3. Current liabilities – Rent of the shop + money you owe to manufacturer
4. Net Working Capital (NWC) = Current assets – Current Liabilities
= 2.5 lakh – 70 thousand
= 1.8 lakh
So, at the starting of the month, you have an NWC of 1.8 lakh to run your business.
So, at the starting of the month, you have an NWC of 1.8 lakh to run your business.
In accounting terms, Working capital is the amount maintained at a given time, in the form of Inventories, Account Receivables (or debtors), and the money kept in bank/ cash box. And if you remember, these items comprise current assets in the balance sheet. Working capital that includes only current assets is called Gross Working Capital.
Unlike Fixed Assets that are meant for business use, current assets are intended for sale or conversion. Current assets keep fluctuating with time, and hence, for this reason, Working Capital is also called “Fluctuating Capital.”
Fixed assets provide the infrastructure for your business; the Working Capital provides funds for its day-to-day operations – like payment of employee costs, procurement of services, inventory purchasing, etc. Like a vehicle that doesn’t run without gasoline, the business’s infrastructure will remain idle without working capital. Hence in a way, working capital provides a lifeline to its fixed assets.
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Types of Working Capital
a) Fluctuating Working Capital
Reasons for fluctuation of working capital –
(a) Seasonal – Due to seasonal changes, the level of activities of your business can be higher than usual in some months. Therefore your company will require additional working capital along with the permanent working capital. Hence, during peak season, demand rises, and more stock is maintained to meet the demand.
(b) Special – You may require additional doses of working capital to face cut-throat competition in the market or other contingencies like strikes, lockouts, theft, etc.
Let’s take the consumer goods industry, for instance. In the consumer goods industry, the demands for Finished Goods (FG) increase during the festival season, which in turn increases the amount of working capital required to meet the demand.
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Permanent Working Capital
To carry on everyday operations of the business without any obstacles, finished goods, a certain minimum level of inventory, work-in-progress, and cash must be maintained continuously. The amount required to maintain current assets on this minimum level is called regular or permanent working capital.
Factor Affecting Working Capital Requirement
The working capital requirement of a business is closely related to the following factors.
● Nature of the business – A service firm, such as the electricity utility or a transport corporation with a short operating cycle and sales predominantly on a cash basis has a modest working capital as compared to a machine tool manufacturing business that has a long operating cycle and sells mostly on credit to customers
● Size of business – a large company with high investment in fixed assets will require a higher quantum of working capital as compared to a smaller company belonging to the same industry
● Production cycle – Some capital goods industries like building power plants have a long operating cycle, extending to several months or even a year; customers will only pay after the power plant is commissioned and fully operational. Hence, the Working capital required is higher
● Type of industry – A business in a highly seasonal industry (such as Air conditioning or manufacturing of firecrackers) will have a high working capital build-up for the peak season sales
● Business fluctuations – Business fluctuations may be in the direction of boom or depression. During the boom period, the firm will have to operate at full capacity to meet the increased demand, which in turn, leads to an increase in the level of inventories and book debts. The depression phase of business fluctuations has exactly the opposite effect on the level of the working capital requirement.
● Access to banking facilities – If a firm can get an easy bank facility in case of need, it will operate with less working capital. On the other hand, if such a facility is not available, it will have to keep a large amount of working capital.
● Profit and taxes – Moreover, the full amount of cash profit is not available for working capital purposes. Taxes have to be paid out of profits. The higher the amount of taxes- the less will be the profits for working capital.
Hence, the size of the Working Capital should correspond to the size of the business and the peculiarity of the industry to which the company belongs.
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Working Capital Cycle
By now, you must have realized the importance of working capital and how critical it is to ensure the smooth functioning of a business.
Understanding the concept of an operating cycle is going to be very important to estimate the working capital required for your business.
According to Wikipedia, The working capital cycle, also known as the operating cycle, is the amount of time it takes to turn the net current assets and current liabilities into cash. The longer the cycle is, the longer a business is locking up capital in its working capital without earning a return on it. Companies tend to reduce their operating cycle by collecting receivables quicker or sometimes extending accounts payable.
In the retail industry and restaurant business, the operating cycle is very short (maybe a few days or even just for a day) when the inputs are converted to finished goods and sold across the counter for cash. Hence, the working capital required is lower. On the other hand, some capital goods industries like Commercial Real-estate have a long operating cycle extending years; customers will only pay after the project is delivered and fully operational. Hence, the Working capital required is higher.
Let’s take an example to calculate working capital using the concept of “operating cycle”.
Say you have a garment business. The projected Income statement of your business for 2019 is visible to you. Assume 360 days in a year and all the amounts in lakhs.
|Raw material stock||45 days|
|WIP stock||10 days|
|Finished Goods stock||6 days|
|Cash requirement||5 days|
We need to estimate the working capital requirement for the garments business. You can see that the money value of raw material to be used in a year is Rs 2,400 lakh. If a year has 360 days, then for 45 days, the monetary value of raw material to be kept would be Rs 300 lakhs. Similarly, the money value of Work In Progress to be used in a year is Rs. 3,600 lakhs. If a year has 360 days, then for 10 days the monetary value of WIP to be kept would be Rs. 100 lakhs. Likewise, we can find out the value of other current assets. For finished goods, it will be Rs. 60 lakhs, for receivables it will be Rs. 500 lakhs and for cash, it will be Rs. 75 lakh the total requirement of working capital, thus, will be Rs. 1035 lakhs.
As an entrepreneur, you should be able to estimate the working capital requirement for your business using the ‘operating cycle’ concept.
Hurray! Net Working Capital is no more alien to you. You now understand the importance of working capital management. It is going to be very important to be careful as an entrepreneur, accurately estimate your working capital requirements and plan for them accordingly so that you maintain enough solvency for your business.