Working capital is basically the cash a business needs for its daily operations, like paying bills, rent, and wages. You can figure out how much working capital a business needs by subtracting its current liabilities from its current assets, using this simple formula: Working Capital = Current assets – Current liabilities.
Why Working Capital Matters
Managing working capital is essential to ensure a business has enough cash to cover day-to-day expenses. This ensures that the company can consistently pay for upcoming costs, like buying raw materials, especially when there are changes in sales demand.
Types of Working Capital
There are several types of working capital, but let’s focus on the two main types you’ll find in any business:
Temporary Working Capital
Sometimes, businesses experience a sudden increase in demand, often short-term due to events like festivals or changing trends. Seasonal businesses, in particular, often see these demand spikes. Temporary working capital is essentially the extra cash needed to handle these temporary demands.
When demand unexpectedly rises, a company needs to purchase more raw materials to ramp up production. The money needed for these additional production costs falls under temporary working capital. This type of funding is temporary because the increased demand won’t last forever, easing the working capital requirements over time.
Depending on the business, temporary working capital can be:
1. Seasonal WC: For businesses like tourism or winter clothing, demand rises during specific seasons. This requires funds for buying raw materials and hiring extra help, known as seasonal working capital.
2. Special WC: Sometimes, demand unexpectedly spikes for reasons other than seasonal changes. This calls for special working capital because these instances are random and not part of a regular pattern.
Permanent Working Capital
Some businesses must always maintain a certain level of current assets throughout their operations. This situation often arises when customers are slow to pay compared to the payment terms with suppliers, leading to a constant need for additional capital. Managing working capital in these scenarios is a year-round task to ensure the business has enough liquidity to meet its current liabilities while maintaining its current assets.
There are two types of permanent working capital:
1. Regular WC: This is needed to cover ongoing costs during growth phases. Effective working capital management ensures funds are available throughout the growth period, possibly by using a short-term business loan.
2. Initial WC: This covers the initial working capital needs when starting a business. After meeting this first need, cash from sales typically means no additional capital is required for working capital. This is common in new or static businesses.
Understanding these two types of working capital can help you figure out how much capital your business needs and the external funding you might need to secure.
