Working capital is a financial metric that represents operating liquidity accessible to business. In simpler words, it indicates the funds available to support a company’s everyday operations.
It is regarded as the lifeblood of any organisation, and without working capital, it impossible to stay in business.
Moreover, investors always look at a company’s working capital before investing in it. It portrays a firm’s short-term financial health as well as its liquidity. Therefore, the effective and efficient management of this capital is vital to keep a business alive.
How is it calculated?
Working capital represents the difference between current assets and liabilities. Current assets signify any asset, which can be converted into cash quickly and within a specific period. For example, inventory is a form of a current asset as it is sold, and the company receives cash from such transactions.
Current liabilities, on the other hand, represent short-term liabilities, which will be repaid within a period. For instance, a short-term loan which will be repaid within this financial year.
Thus, Working capital = Current Assets – Current Liabilities
Working capital and health of a business
Positive working capital is a good sign for every company. It indicates that this particular business has the financial capacity to pay off all kinds of liabilities. In contrast, a negative working capital suggests that a company is financially incapable of managing its obligations.
Everyone outside the company can get a clear idea of its financial health by looking at working capital figures.
It also shows how the inventory, accounts receivables, accounts payable, cash in hand, etc. are being managed. If these accounts are managed efficiently, it will automatically reflect in working capital.
Working capital ratio
The working capital ratio is another way of analysing a company’s financial health. This ratio can be found by dividing current assets by current liabilities. With the help of this ratio, companies can determine how much working capital a business needs.
Working Capital Ratio = Current Assets / Current Liabilities
If this ratio is less than 1.0, it indicates a negative working capital. It means the number of current liabilities outweighs that company’s current assets.
However, a high working capital ratio is not a positive trait for a business. It indicates that a firm has excess inventory, or there is a shortage of investment.
Now the question is, what is an ideal working capital ratio? Well, it varies from one industry to another, but anything in the range of 1.2 to 2.0 is considered as a good one.
Importance of managing working capital ratio
Working capital is imperative to the survival of every business. Thus, it is vital to manage it efficiently so that business never runs out of working capital.
Here are its advantages –
- Effective management of working capital improves a company’s credit profile. It gives firms the ability to meet their short-term credits and improves their long term solvency. Adequate management enables an organisation to repay its debts on time.
- Several pieces of research have indicated that efficient management of account receivables and payable can surge a company’s profit.
- Companies with effective management of working capital tend to generate more cash flow into the business. This drives up the valuation of a firm.
- Working capital management allows a firm to tackle any unprecedented circumstances. It helps businesses to survive during a crisis or increase production in case of a large order.
- As mentioned earlier, proper management of working capital increases cash flow in a business. It helps firms to pay their suppliers on time, which ensures uninterrupted production.
- Last but not least, efficient management of working capital increases liquidity in the business. It aids firms to allocate their resources better and improve their cash management.
In case of a working capital crunch, firms can source some funding by availing capital loans. Prominent NBFCs like Bajaj Finserv offer affordable business loans to help companies recover from a working capital shortfall. They can avail up to Rs.30 lakh at an attractive interest rate and flexible tenor.
Furthermore, the company has also introduced pre-approved offers on business loans. These offers aim to make the loan application process easy and time-saving. One can utilise such offers on other secured and unsecured financial products like personal loans, credit cards and more.
Appropriate management of working capital is the hallmark of a good business. It portrays a company’s financial health and its operational success as an organisation. Therefore, it essential to manage working capital efficiently to strike a balance between growth, liquidity and profitability.