Working Capital Meaning – Importance & Advantages

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Working Capital Meaning – Importance & Advantages

In a business, there are two financial metrics that owners or businesses keep a close eye on: the working capital levels and the cash flow status. Both financial metrics help businesses to know whether their company will be able to withstand a market downturn or crisis successfully or not.

In this blog, we will understand the working capital meaning, its importance, and its advantages.

What is a Working Capital?

Working capital refers to the liquidity level of the business that covers the day-to-day expenses and other short-term expenses. It indicates the short-term financial position or feasibility of the business and how well the company can manage its short-term financial obligations.

The working capital formula is the current assets minus the current liabilities of the business organization.

Working Capital = Current Asset - Current Liabilities

Current assets include raw materials, inventory, cash at hand and bank, account receivable, etc. On the other hand, current liabilities include accounts payable, wages, taxes, short-term debt, interest owed, etc.

A positive working capital indicates the company has enough funds to cover its daily expenses and short-term debt.

Whereas, negative working capital is a situation where current liabilities exceed current assets, meaning, the business is struggling to finance the day-to-day expenses of the business and indicates a financial crisis.

Must Read: What are the Different Types of Working Capital?

Importance of Working Capital

For any business organization, having adequate working capital is very important for business growth. As discussed above, the primary purpose of working capital is to finance daily operations, meet all the short-term debt obligations, and continue to have sufficient working capital using the existing resources.

If a company has sufficient working capital, it can continue to pay its employees, and suppliers, pay taxes, and other expenses, even if there are some cash flow challenges.

It helps to improve the creditworthiness of the business, have better bargaining power with suppliers, and improve profitability. In short, having sufficient working capital ensures value creation and plays a vital role in achieving organizational goals and profitability.

Advantages of Sufficient Working Capital

The following are the top 10 advantages of having adequate working capital:

  • Helps in maintaining the solvency of the business by ensuring an uninterrupted production cycle
  • Prompt payments to suppliers help to improve goodwill as well as the creditworthiness of the business in the market
  • With good credit standing in the market, you can easily avail of a business loan with flexible terms & conditions
  • Can avail of cash discounts from suppliers on making an upfront payment, helping to reduce costs and improve profitability 
  • By properly managing the working capital requirements, the business can weather any financial crisis or market downturn
  • Can take greater advantage of favorable market conditions by quickly responding to the increased demand or changing trends in the market
  • When you have adequate working capital, you can sweat the fixed assets to increase the productivity of the business
  • Can make perfect investment plans and maximize returns on investments for the shareholders
  • Strengthens work culture of the entity as timely payment of all due to employees motivates employees and creates a good working environment
  • Improves overall efficiency of the business and greater competitiveness in the market, which results in increased work contracts

What is Working Capital Management?

Working capital management is a process of managing a company's current assets and current liabilities in the most effective way to maintain sufficient cash flow and meet all the short-term goals. The goal of effective working capital management is to reduce the operating cycle, free-up cash from the balance sheet, maintain liquidity and reduce dependency on external sources for financing working capital needs. 

The efficiency of working capital management can be quantified in three ratios- current ratio, collection ratio, and inventory turnover ratio. 

  1. Current Ratio- It is calculated by dividing current assets by current liabilities and is a key indicator of the financial health of the company. Companies aim to maintain the current ratio above 1.00, generally indicating the company's current assets can easily cover all the current liabilities and meet all short-term obligations. 
  2. Collection Ratio- It is also known as days sales outstanding that measures how efficiently a company manages its account receivable. It is the company’s account receivable to its average daily sales. It indicates the number of average days it takes to convert receivables into cash. 
  3. Inventory Turnover Ratio- It measures the efficiency in inventory management and is one of the most important ratios for determining efficiency in working capital management. It is calculated by dividing the cost of goods sold by the average inventory for the same period. A higher ratio indicates strong sales, while a low ratio indicates weak sales. 
Must Read: Business Finance - Know its Meaning

5 Ways to Increase Working Capital

A business may experience a drop in working capital due to unexpected market conditions or increased expenses in other areas of business. In such a case, the business needs to take steps to improve working capital to ensure stability and remain competitive in the market. The following are the top 5 ways to increase working capital:

  1. Taking Short/Long-term Debt: You can go for availing of a working capital loan from your lender and the loan tenure usually ranges between 6 to 48 months. Further, you can consider refinancing your short-term loan and converting it into a long-term loan.
  2. Reducing Expenses: Analyze the current expenses incurred for running the business and cut down on expenses wherever possible without reducing operational efficiency. 
  3. Inventory Management: Optimize the inventory management process and reduce overstocking of raw materials and finished goods. 
  4. Selling Illiquid Assets: Take steps to monetize illiquid assets for cash, which will improve the cash position of the business
  5. Automate Account Receivable Process: It will help to shore up cash position by improving cash flow from operating activities, reducing the need to draw funds from any other sources for day-to-day operations.

Conclusion

If you are choosing to avail of a business loan to meet working capital requirements with Fullerton India, you must check your eligibility for the loan before applying. By using the business loan eligibility calculator, you can check your eligibility for the loan instantly and the amount you can borrow. 

You can also use Fullerton India’s business loan EMI calculator to choose the right loan tenure and EMI to increase the chances of loan approval.