Working Capital Of A Business

Net working capital financing assumptions are inferred from a company’s balance sheet’s financial assets and corresponding liabilities. Cash, receivable accounts, stock, and other comprehensive income to be liquidated or converted into cash in much less than a year are classified as current assets. Payables, salaries and benefits, taxes, and the prevailing fraction of long-term payments due within a year are instances of current liabilities. 

Working Capital

Working capital is also referred to as net working capital. It is the difference between the business’s current assets and current liabilities. 

• The current assets include cash, accounts receivable, unpaid bills from customers, material inventories, and completed products. 

• The current liabilities of the business include accounts payable and debts.

The net working capital financing of a company is a way of measuring its liquidity, operating excellence, and short-term liquidity position. If a company has a significant positive net working capital, it should invest and expand. If a company’s current assets do not surpass its current liabilities, it may struggle to grow or repay creditors. The company may even declare bankruptcy. 

Calculation Of Net Working Capital

Net working capital is computed by considering the current assets and current liabilities of a company. The existing assets are to be subtracted from the current liabilities. Cash, receivable accounts, and stock are examples of current assets. Payables, short-term loan repayments, and the existing portion of deferred income are instances of current liabilities. 

Let’s understand the calculation of net working capital financing with an example.

ABC ltd, has $200,000 in current assets and $170,000 in current liabilities. We shall compute the net working capital of the company.

Current assets = $200,000  

Current liabilities = $170,000

Net working capital = 

Current assets – Current liabilities

= $200,000 – $170,000

Net working capital = $30,000.

Changes Made To Current Assets And Liabilities To Increase Net Working Capital

To improve the working capital financing, a business can hold more cash in the form of reserve and postpone payments to their suppliers to decrease current liabilities. Let’s understand this with an example.

XYZ Corp. is in manufacturing shoes. When XYZ initially incorporated their business, net working capital was Rs.20,000, wherein their current assets were averaging to Rs.50,000, and current liabilities were averaging to Rs.30,000. XYZ corp decided to improve its net working capital. They took measures, kept more cash in reserve, purposely delayed their payments to dealers and shortened the credit period allowed to the customers. This facilitated the reduction of the current liabilities of the company. Therefore, its net adequate working capital was recorded around Rs.40,000. Therefore, its net adequate working capital recorded s Rs.40,000.

Importance Of Net working Capital

Net working capital is significant since it is required for enterprises to stay in business as solvent participants. Even when a company makes a profit, there are possibilities for the company to declare bankruptcy. A company cannot depend on profits available on documents to repay their debts; The bills should be reimbursed in terms of cash. For example, a company records a $1 million cash reserve on retained earnings. All these earnings are from previous years. If the company spends the entire $1 million on investment, it shall be left with insufficient current assets to cover its current liabilities.

Sources Of Working Capital

The sources of working capital can be divided into three categories: short-term, long-term, and spontaneous. Tax Specific provisions or dividend income, certificates of deposit, cash credit, short-term lending, trade deposit accounts, inter-corporate lines of credit, corporate bonds, and undervaluing bill sources of short-term investment are all instances of short-term capital. Long Term capital deals with the categories of long-term financing, retained earnings, depreciation arrangements, owners’ equity, and debentures. Trade credit, which includes bills and notes to be paid, is the primary source of spontaneous adequate working capital. So, based on their requirements, the business entity has these three working capital types.

Benefits Of Net working Capital

The benefits offered by the Net working capital of a business are as follows:

• It allows for a smooth flow of production.

• Aids in increasing liquidity

• It also guarantees that fixed assets are used appropriately.

• It assists a project in gaining a favourable reputation for the business.

• It also allows the company to take advantage of cash discounts.

• Facilitates in the easy acquisition of financial assistance such as loans

• It also empowers an efficient response to contingencies. 

Conclusion

The working capital of a business reveals the financial condition of a company. To calculate the working capital, the entity’s current liabilities are deducted from its total current assets. This ratio indicates if the organization seems to have enough assets to manage its short-term liabilities. Hence, working capital signals an organization’s liquidity levels for meeting day-to-day expenses, accounts payable, stock, receivable accounts, and short-term borrowing dues.

Suppose you are preparing for IIT JEE or NEET examination. In that case, it is advised to use Study material notes on the working capital of a business better to understand the theory and concept of this chapter. Working capital of a business study material facilitates you to understand the working capital financing, sources of adequate working capital, and benefits of the working capital of a business.