Running your business successfully on a day to day basis requires adequate cash flow. With competing operational demands, realistically estimating working capital needs is crucial. Find out more below.
What is working capital and why do you need it?
For a business to function smoothly, a steady flow of working capital is absolutely essential. Working capital refers to cash and other assets that a business has on hand, for daily operational requirements such as rent, utilities, payroll, inventory, etc. Calculated as the difference between the current assets and current liabilities of a company, working capital is the amount that is left after figuring out what the company owns and owes in the short-term.
For startups, working capital is the amount of money to be borrowed to keep the business afloat, until it starts generating enough profit for funding operational expenses.
Sufficient working capital is necessary for paying off recurring expenses such as buying inventory, investing in infrastructure or managing other overhead costs. Read more to know about the best practices of working capital calculation to maximize short term and long term returns.
Working capital calculation formula:-
The working capital calculation is as simple as subtracting your current liabilities (what your business owes) from your current assets (what your business owns). Current assets can be converted into cash within a year and they include cash, accounts receivable (money owed to the company by debtors), inventories and short-term prepaid expenses, thus any small business can build its brand easily.
On the other hand, current liabilities are the ones that a business needs to pay off within a year which include accounts payable (money owed by the company to creditors), accrued liabilities, accrued income taxes and dividends payable.
To help you figure out your company’s capital requirements, here’s a simple working capital calculation formula:-
Working Capital = Current Assets – Current Liabilities
While doing your working capital calculation, remember to exclude cash commitments like buyback of shares and declared dividends from cash-in-hand. Remove non-trade receivables like loans given to employees and obsolete inventory from the total stock.
An example of working capital calculation:-
Current assets of your company:
- Goods sold on credit: Rs.3, 00,000
- Raw Materials: Rs.2, 00,000
- Cash in hand: Rs.4, 50,000
Deduction from this:-
- Obsolete inventory: Rs.30, 000
- Loans given to employees: Rs.50, 000
The total value of current assets = Rs.3,00,000 + Rs.2,00,000 + 4,50,000 – Rs.30,000 – Rs.50,000 = Rs.8,70,000.
The current liabilities include:
- Outstanding funds payable to creditors: Rs.3, 70,000
- Unpaid expenses: Rs.70, 000
Your business’s total current liabilities = Rs.3, 70,000 + Rs.70, 000 = Rs.4, 40,000.
Therefore, working capital calculation will be= Current assets – current liabilities
Rs. (8, 70,000 – 4, 40,000) = Rs.4, 30,000.
In your working capital calculation, you can also consider the working capital ratio:-
Working Capital Ratio = Current Assets / Current Liabilities
Which is = 8, 70,000 / 4, 40,000= 1.97
How much working capital do you require?
To get the answer to this question you first required to understand the concept of working capital cycle. The concept of the working capital cycle includes two of the main terms. The first one is that how soon the current asset of any company could be turned into cash. Current assets meaning inventory and account receivables within the organisation. The second one is how soon this cash could be used to pay the current liabilities.
To put things into perspective, a working capital ratio of current assets to liabilities higher than 1 means positive working capital. Similarly, negative working capital ratio is classified as any ratio below 1 which indicates short-term cash flow problems.
You need to take action to stabilize the situation right away because if working capital gets too low, it could have consequences for order fulfillment and affect the profitability of your business. On the other hand, a ratio above 2 might indicate that the business has too much inventory and is not invested in long-term growth.
Working capital loan
Businesses need to address the gap in working capital to stay afloat, either through their own reserve of profits or look for external financing. Working capital finance is approved after evaluating a company’s accounts and projected working capital requirements. An important aspect of working capital management is how frequently you pay your creditors and how quickly you can realize your debtors.
In simple words, it is possible to fill the finance gap in any organisation, with a working capital loan. The major reason to opt for a working capital loan is that with this kind of loan, you can easily fund the short term business needs or operational needs. Whenever you feel it’s cash crunch in your business, you may apply for the loan if you fulfill the required eligibility criteria lenders want from you.