What Is Working Capital? How to Calculate and Why It’s Important

In a business, there are two financial metrics that owners or businesses keep a close eye on: the working capital levels and the cash flow status. Both financial metrics help businesses to know whether their company will be able to withstand a market downturn or crisis successfully or not.

In this blog, we will understand the working capital meaning, its importance, and its advantages.

What Is Working Capital?

Working capital refers to the liquidity level of the business that covers the day-to-day expenses and other short-term expenses. It indicates the short-term financial position or feasibility of the business and how well the company can manage its short-term financial obligations.

The working capital formula is the current assets minus the current liabilities of the business organisation.

Working Capital = Current Asset - Current Liabilities

Current assets include raw materials, inventory, cash at hand and bank, accounts receivable, etc. On the other hand, current liabilities include accounts payable, wages, taxes, short-term debt, interest owed, etc.

A positive working capital indicates the company has enough funds to cover its daily expenses and short-term debt.

Whereas negative working capital is a situation where current liabilities exceed current assets, meaning the business is struggling to finance the day-to-day expenses of the business and indicates a financial crisis.

Positive Vs. Negative Working Capital

Positive working capital indicates a company’s ability to cover its short-term liabilities with its short-term assets, signalling financial health and operational efficiency. It allows businesses to seize growth opportunities and manage daily operations effectively.

Negative working capital, on the other hand, suggests potential liquidity issues, where a company might struggle to meet its immediate obligations. While negative working capital can sometimes indicate efficient inventory management in specific industries (e.g., retail or fast-moving consumer goods), prolonged periods of negative working capital might signal risks to long-term financial stability and solvency.

Sources of Working Capital

Sources of working capital include short-term loans, trade credit, bank overdrafts, retained earnings, and advances from customers. Additionally, businesses can utilise inventory financing, factoring, and the sale of non-core assets. These options ensure liquidity for daily operations, helping maintain smooth functioning while avoiding disruptions to long-term financial stability.

Types of Working Capital

There are several types of working capital, each serving specific purposes:

• Permanent Working Capital: The minimum level of capital required to support day-to-day operations. It remains constant over time, ensuring operational efficiency.
• Temporary Working Capital: The difference between permanent and net working capital, and is often needed to address seasonal or fluctuating business demands.
• Gross Working Capital: Refers to the total value of current assets like cash, inventory, accounts receivable, and marketable securities needed for business operations.
• Net Working Capital: The difference between current assets and current liabilities, representing a company’s short-term financial health and ability to meet obligations.
• Positive Working Capital: Occurs when current assets exceed current liabilities, reflecting financial stability and operational efficiency.
• Negative Working Capital: Arises when current liabilities exceed current assets, often indicating liquidity challenges or financial strain.

Working Capital Cycle

The working capital cycle refers to the time it takes for a company to convert its current assets (like inventory and receivables) into cash. It involves purchasing inventory, selling products, collecting payments, and replenishing stock. A shorter cycle improves liquidity, boosts operational efficiency, and enhances profitability.

Advantages of Sufficient Working Capital

The following are the top 10 advantages of having adequate working capital:

• Helps in maintaining the solvency of the business by ensuring an uninterrupted production cycle.
• Prompt payments to suppliers help to improve goodwill as well as the creditworthiness of the business in the market.
• With good credit standing in the market, you can easily avail of a business loan with flexible terms & conditions.
• Can avail of cash discounts from suppliers on making an upfront payment, helping to reduce costs and improve profitability.
• By properly managing the working capital requirements, the business can weather any financial crisis or market downturn.
• Can take greater advantage of favourable market conditions by quickly responding to the increased demand or changing trends in the market.
• When you have adequate working capital, you can sweat the fixed assets to increase the productivity of the business.
• Can make perfect investment plans and maximise returns on investments for the shareholders.
• Strengthens the work culture of the entity as timely payment of all due to employees motivates employees and creates a good working environment.
• Improves overall efficiency of the business and greater competitiveness in the market, which results in increased work contracts.

Limitations of Working Capital

While working capital is crucial for day-to-day operations, it has limitations. Excessive working capital can indicate inefficient use of resources, leading to low returns on investments. On the other hand, insufficient working capital can result in liquidity problems, affecting a company’s ability to meet short-term obligations. Additionally, working capital does not account for long-term investments or financial stability, and relying solely on it may overlook other critical financial aspects such as profitability and growth potential.

Examples of Working Capital

Working capital includes various financial assets that support a company's daily operations. For example, cash provides liquidity for immediate expenses, while accounts receivable represents money owed by customers for goods or services provided. Inventory, including raw materials, work-in-progress, and finished products, ensures that a company can meet demand. Additionally, accounts payable reflect short-term debts to suppliers, and prepaid expenses are payments made in advance for future services. Together, these elements maintain operational efficiency and business stability.

Importance of Working Capital

For any business organisation, having adequate working capital is very important for business growth. As discussed above, the primary purpose of working capital is to finance daily operations, meet all short-term debt obligations, and continue to have sufficient working capital using the existing resources.

If a company has sufficient working capital, it can continue to pay its employees and suppliers, pay taxes, and other expenses, even if there are some cash flow challenges.

It helps to improve the creditworthiness of the business, have better bargaining power with suppliers, and improve profitability. In short, having sufficient working capital ensures value creation and plays a vital role in achieving organisational goals and profitability.

What Is Negative Working Capital?

Negative working capital occurs when a company's current liabilities exceed its current assets. This situation can indicate potential liquidity issues, as the business may struggle to meet short-term obligations with available resources. It may arise if a company has high levels of debt, slow-moving inventory, or extended credit terms with suppliers.

While negative working capital is typically seen as a red flag, some businesses, particularly in industries with fast inventory turnover or high levels of prepayments, may operate efficiently despite it. However, sustained negative working capital can lead to financial strain and challenges in managing day-to-day operations.

How Can a Company Improve its Working Capital?

To improve working capital, a company can:

• Accelerate Accounts Receivable: Collect payments faster by offering discounts or improving credit control.
• Reduce Inventory Levels: Optimise inventory management to avoid excess stock.
• Negotiate Better Payment Terms: Extend payment periods with suppliers to retain cash longer.
• Increase Sales: Boost revenue without immediately increasing costs.
• Refinance Short-term Debt: Convert short-term debt into long-term obligations for better cash flow management.
• Control Operating Expenses: Reduce unnecessary expenses to improve cash retention.

What Is Working Capital Management?

Working capital management is a process of managing a company's current assets and current liabilities in the most effective way to maintain sufficient cash flow and meet all the short-term goals. The goal of effective working capital management is to reduce the operating cycle, free up cash from the balance sheet, maintain liquidity and reduce dependency on external sources for financing working capital needs.

The efficiency of working capital management can be quantified in three ratios - current ratio, collection ratio, and inventory turnover ratio.

1. Current Ratio: This is calculated by dividing current assets by current liabilities and is a key indicator of the financial health of the company. Companies aim to maintain the current ratio above 1.00, generally indicating the company's current assets can easily cover all the current liabilities and meet all short-term obligations.
2. Collection Ratio: It is also known as days sales outstanding that measures how efficiently a company manages its accounts receivable. It is the company’s accounts receivable to its average daily sales. It indicates the number of average days it takes to convert receivables into cash.
3. Inventory Turnover Ratio: It measures the efficiency of inventory management and is one of the most important ratios for determining efficiency in working capital management. It is calculated by dividing the cost of goods sold by the average inventory for the same period. A higher ratio indicates strong sales, while a low ratio indicates weak sales.

5 Ways to Increase Working Capital

A business may experience a drop in working capital due to unexpected market conditions or increased expenses in other areas of business. In such a case, the business needs to take steps to improve working capital to ensure stability and remain competitive in the market. The following are the top 5 ways to increase working capital:

1. Taking Short/Long-term Debt: You can avail of a working capital loan from your lender and the loan tenure usually ranges between 6 to 48 months. Further, you can consider refinancing your short-term loan and converting it into a long-term loan.
2. Reducing Expenses: Analyse the current expenses incurred for running the business and cut down on expenses wherever possible without reducing operational efficiency.
3. Inventory Management: Optimise the inventory management process and reduce overstocking of raw materials and finished goods.
4. Selling Illiquid Assets: Take steps to monetise illiquid assets for cash, which will improve the cash position of the business.
5. Automate Accounts Receivable Process: It will help to shore up cash position by improving cash flow from operating activities, reducing the need to draw funds from any other sources for day-to-day operations.

Conclusion

If you are choosing to avail of a business loan to meet working capital requirements with SMFG India Credit, you must check your eligibility for the loan before applying. By using the business loan eligibility calculator, you can check your eligibility for the loan instantly and the amount you can borrow.

You can also use SMFG India Credit’s business loan EMI calculator to choose the right loan tenure and EMI to increase the chances of loan approval.