Working capital refers to the cash liquidity that a business needs in order to operate the business on a day-to-day basis. It is the minimum amount needed to pay for utility bills, rent, wages, etc.
The working capital needs of a firm can be achieved by subtracting its current liabilities from current assets. Hence, the generally accepted working capital formula of a business is:
Working Capital (WC) = Current asset – Current liabilities.
Importance of WC
Working capital management is required to ensure that the firm has enough liquidity to meet its day to day monetary needs. It ensures smooth cash flow by ensuring that the company is financially strong enough to meet its upcoming liabilities. These liabilities generally arise from purchases of raw materials to meet fluctuations in sales.
Types of WC
However there are kinds of working capital available including gross or net, temporary, permanent, negative, reserve, regular and many more. But here we will discuss two of the major kinds of working capital required in any business. They are:
Many times, companies face a sudden surge in demand, which may be for a short period. It can be due to reasons like festivals or a change in trend. Seasonal businesses generally witness these kinds of demand surge. So in simple words, we can say that temporary working capital is a kind of additional working capital that could be needed from time to time or over a time period.
Now, when a company sees a sudden increase in demand, it needs to buy additional raw materials to meet the demand by producing more. The cash required to meet this additional cost of production is referred to as temporary WC. The funds are temporary in nature because this demand generally dies over time, which reduces the working capital needs.
According to the nature of business, temporary WC can be of two types. They are:
- Seasonal WC: In case of seasonal businesses like tourism or winter garments, with onset of a specific season, the demand can be generally expected to rise. Purchase of raw materials and employment of additional labour requires funds. This fund is known as seasonal WC.
- Special WC: Sudden and unforeseen risein demand are special cases. These are unexpected and therefore, require special WC. It is special in a sense that these are not seasonal or repetitive in nature. They do not follow uniform intervals as seen in case of seasonal demand surge.
- Permanent WC
Some businesses need to maintain a specific level of current asset throughout the operating cycle. When the debtors take more time in paying their dues when compared to time allowed by creditors, such companies are in constant need of additional capital. Working capital management in this case needs to be carried out throughout the year. It ensures the firm has enough liquidity to finance its current liabilities while maintaining current assets.
There are two types of permanent WC:
- Regular WC: Funds required in covering the cost of growth calls for regular WC. In this case, working capital management should be done in a way that ensures availability of funds throughout the growth period. It can be done by use of a short-term business loan.
- Initial WC: It is required to fund the initial WC needs of a business. Once this need is met, an additional fund for WC is not required due to the cash receipts from sales. It is generally seen in new or stagnant businesses.
Once you understand the concept of the two types of working capital, you will be able to determine how much capital your business needs. The same can also help you determine the amount of external funding you must secure.