Working Capital Management: Meaning & Types
What is Working Capital Management?
Every business needs to perform a certain set of activities to make sure it has got enough resources for meeting its daily operating expenses. This is what working capital management essentially is.
Working capital refers to the difference between your company’s current assets and current liabilities. Current assets are your highly liquid assets like cash, accounts receivable, and inventories. Basically, they are everything that can be easily converted into cash within a year.
On the other hand, current liabilities are any obligations due within the coming twelve months. These include accounts payable, short-term borrowings, and accrued liabilities.
For your business to operate efficiently, you need to monitor both of them and use them as effectively as possible. The purpose, primarily, is to maintain an adequate amount of cash flow to meet your short-term operating costs and short-term debt obligations.
Types of Working Capital
Temporary Working Capital
If you could recall, your business needs capital during some specific times of the year, for example, in the festive season. Such a requirement, that is temporary and fluctuates according to a business’s internal operations as well as the external market conditions, is termed as temporary working capital.
In other words, you require not more than a short-term loan to finance your temporary requirements, which is repayable as soon as the cash starts rolling in. However, it’s never easy to forecast this kind of working capital.
Permanent Working Capital
Permanent working capital is everything temporary working capital is not. It is required to make liability payments even before your assets or invoices are converted into cash. This kind of capital is crucial as it is the minimum working capital required for your business to function uninterrupted.
While forecasting the value of your current assets is often challenging, it is possible to find a level below which a current asset has never gone. The current assets below this level are your permanent working capital. This can be done mainly on the basis of historical trends and experiences.
Gross & Net Working Capital
As the name suggests, gross working capital means the total of all your company’s assets that can be converted to cash within a year. Another way to describe this is as the ratio of all your current assets to your current liabilities.
On the contrary, net working capital is your current assets minus your current liabilities. Since this is that part of your current assets which are indirectly financed by long-term assets, it is considered relatively more significant for effective working capital management.
Negative Working Capital
If your current liabilities are in excess of your current assets, it represents negative working capital. There is more short-term debt as compared to short-term assets. This can actually prove useful for your business as one can fund their growth in sales by effectively borrowing from their suppliers and customers.
Regular Working Capital
Businesses normally require some capital just for things to flow smoothly. The least amount required for the same is known as regular working capital. Whether you have to make monthly salary payments or bear the overhead expenses for processing raw materials, the stability of your operations will depend largely on your regular working capital.
Reserve Working Capital
Reserve working capital is the capital over and above your regular working capital. Businesses keep such funds to meet financial requirements that may arise due to unexpected market situations or opportunities.
Special Working Capital
In case one’s temporary capital increases due to a special and abnormal event, it is referred to as special working capital. This can’t be forecasted as it is needed quite rarely. For example, in a country where a cricket world cup tournament is going to be hosted, many businesses might need special working capital due to the sudden rise in business.
Importance of Working Capital Management Today
According to a report, net cash from operations have fallen this year across Indian manufacturing companies. This is because the trade receivables have risen while payments have been delayed in the market.
Moreover, small and mid-sized companies are seeing lower credit through trade payables. Consequently, all of that pressure is being put on cash from operations. Thanks to the supply chain constraints, most businesses have locked in more of their funds in inventories.
Limited availability of cash, poorly managed commercial credit policies, or constrained access to short-term financing can lead to the need for restructuring, asset sales, and even liquidation of a business.
Therefore, to protect your company’s existence, you must ensure that your business doesn’t fall short of working capital. Always make sure your business possesses appropriate and adequate resources for its daily activities.