Working capital (WC) is the difference between current assets and current liabilities. The monitoring and proper utilization of these two are known as working capital management (WCM).
You have to know all about WC and how it affects a business before you know how it is managed for maximum business efficiency.
What is working capital (WC)?
Working capital refers to that part of the total capital required to maintain current assets after paying off the current liabilities. In simpler words, it is the amount of money required to meet day-to-day production costs.
Working capital helps a business concern to maintain steady cash flows. It ensures that the firm does not face a shortage of liquidity even if debtors take more time in paying up.
Components of WC
As mentioned earlier, the main components that determine WC requirements are:
These are short-term expenses of a company. Current liabilities include trade creditors, short term loans, bills payable and other similar short term payment obligations of a firm.
These are short term assets that are required during the production cycle. Current assets include resources like cash at bank, inventory, trade debtors and other similar short term assets.
The generally accepted working capital formula used for calculation working capital needs is quite simple:
Working Capital (WC) = Current asset – Current liabilities
Therefore, if you want to know how to calculate working capital requirements for your business, use the following mentioned above.
It refers to managing the availability of funds required to meet WC requirements. Efficient WC management will ensure that the business concern has enough liquidity to take advantage of a sudden rise in demand. Surges in demand can be seen in cases of a seasonal business and some special cases.
In order to meet higher demands, the firm has to produce more which entails additional expenses in current assets like raw materials and labor payments.
Therefore, working capital management ensures that the business has enough funds to meet these short term expenses required to maintain enough current assets to produce more in times of higher demand. This is why WC finance is necessary for small businesses because of their growing demand.
Approaches of WC requirement
The three main approaches or strategies of WCM are mentioned below:
In this strategy, managers determine the long term capital requirements of the business and the short term working capital requirements. After determining, they avail funds accordingly.
For long-term requirements, they opt for secured loans and for the short-term needs an unsecured loan matching the term period is availed. It ensures efficient utilization of monetary resources to meet working capital needs.
In this approach, the managers tend to take high levels of risk by always opting for short-term funds as soon as the need arises. This policy reduces the cost of the loan. However, the degree of risk involved is quite high. This is because it only has enough funds to finance a certain level of production. In cases of a sudden increase in demand, the firm may fail to avail of working capital loans quickly enough to take advantage of the opportunity.
In this policy of working capital management, the managers depend heavily on long term funds. It increases the cost of funds while decreasing the level of risk involved considerably. A conservative approach ensures that enough funds are available all-round the year to meet demand surges.
These are the basic components and strategies of WC management. Make sure you understand them as it will help you understand the needs of your business.