Those involved in the world of accounts will tell you that a business is as strong as its working capital, though there are others who would beg to differ. But whatever the consensus on that may be, we know that in a business, this capital is essential. However, how exactly can we define this, and how is it determined?
Simply put, working capital is the difference between current assets and current liabilities, and it is the amount of liquefiable capital available to a company to build itself. It doesn't mean that this capital will always be positive, there are times when it can be negative, and this happens when the current assets are less than the current liabilities. More importantly, a company needs this capital for its day-to-day activities like those of paying wages, buying raw material, and settling bills. When a company finds itself short of this capital, it uses its current assets to get money.
We have already understood the fact that it is essential for a business, in fact, in some cases, it is the essence on the basis of which the business functions. But why is it so essential? Basically, it is needed for the smooth functioning of the business. A business, in fact, requires just the right amount of it; too much and too little can be detrimental.
Elements of Working Capital
This capital has certain elements and for a business to function smoothly, it needs to be aware of these.
This is probably the most essential element or component of working capital. Without cash a business cannot run smoothly. But cash in the business needs to be monitored carefully along with proper budgeting and forecasting. Cash inflow and cash outflow need to be monitored as well.
Every business has some debtors, people, or other businesses that owe them money. These are called accounts receivable. Simply put, these are amounts that are yet to be received from debtors. Accounts receivable have to be monitored properly and checked.
Inventory or Stock
The inventory in a company is half of its current assets and hence needs more monitoring than everything else. The level of the inventory or stock needs to be at a particular level, the rate of turnover also needs to be monitored closely.
Like every company has debtors, people who owe you money, similarly every company has creditors to whom they owe money. Its normal for businesses to owe money to their suppliers and other businesses; this is because sometimes the amounts to be paid are large and will need some time to be paid off. It is important to track these amounts, also called accounts payable, not only for the purpose of working capital, but also for goodwill reasons.
Outstanding Expenses and Payable Taxes
These are certain outstanding expenses that the company has and that will reflect on the capital.
Each company has different requirements for this capital, depending on different factors, and these are:
- Type of business
- Size of business
- Production policy
- Process of manufacturing
- Changes in seasons
- Working capital cycle
- Turnover rate of inventory
- Policy for credit
- Business cycles
- Rate at which business grows
- Changes in pricing
- Dividend policy and capacity of earning
We now know how important working capital is, but what happens to the business when there isn't sufficient capital? Immediately affected will be the fixed assets, that won't be able to function properly because of lack of working capital. There is always the risk of dissolving the company because it cannot sustain due to this lack. The credibility of the company will also be affected; all these will just result in bad losses, and like mentioned before, the liquidation of the business to cope with these losses.