Working capital is basically the cash a business needs to keep things running smoothly day-to-day, like paying utility bills, rent, and wages. You can figure out a company’s working capital by subtracting its current liabilities from its current assets, which is generally calculated as:
Working Capital (WC) = Current Assets – Current Liabilities.
Why is Working Capital Important?
Managing working capital is crucial for ensuring a business has enough cash flow to cover its daily financial needs. It helps the business stay financially strong and ready to meet upcoming costs, often resulting from purchasing raw materials to deal with changes in sales.
Types of Working Capital
There are various types of working capital, including gross, net, temporary, permanent, negative, reserve, and regular, among others. Here, we’ll focus on two major types that any business might need:
Temporary Working Capital
Sometimes, a business experiences a sudden increase in demand, often due to seasonal trends or changes in consumer preferences. For example, during festivals or shifts in trends, businesses might see temporary spikes in demand. In such cases, they need extra working capital to cover additional production costs. This funding is temporary because the demand is expected to decrease over time, reducing the need for extra capital. Temporary working capital can be divided into two categories:
– Seasonal Working Capital: This applies to businesses like tourism or winter clothing, where demand rises with the season. They need funds to buy raw materials and hire extra labor, and this funding is known as seasonal working capital.
– Special Working Capital: This kicks in when there’s an unexpected surge in demand that isn’t seasonal or repetitive. Because these surges don’t follow a predictable pattern, this type of working capital is needed on special occasions.
Permanent Working Capital
Certain businesses need a consistent level of assets throughout their operations. If customers take longer to pay than the time allowed by creditors, these businesses need additional capital all year round. Managing working capital in such cases ensures they have enough liquidity to meet current liabilities while keeping assets stable. Permanent working capital can also be split into two types:
– Regular Working Capital: This is needed to support business growth. Effective working capital management ensures there are always funds available during growth periods, often through short-term business loans.
– Initial Working Capital: This is crucial for meeting the initial needs of a new or stagnant business. Once the initial needs are covered, no additional funds are required since cash from sales usually covers ongoing requirements.
By understanding these two types of working capital, you can determine how much your business needs and how much external funding to secure.
