Working capital is the term which is used in finance it refers to that capital which is used by the company in day to day operations, arithmetically it can be calculated as current assets minus current liabilities. However mere knowledge of definition is not sufficient as there are many questions that cannot be answered just by knowing its meaning. Given below are some of the frequently asked questions on working capital –
Working Capital FAQ
How to Calculate Working Capital
The calculation of working capital is quite easy because it is nothing but difference between current assets of the company and current liabilities of the company where current assets include items like cash, cash in bank, debtors, closing stock, bills receivables while current liabilities include items like sundry creditors, bills payables, short term debt, outstanding expenses and so on.
Can Working Capital be Negative
Working capital can be negative and that happens when the current liabilities of the company exceeds the current assets of the company, while for short period of time negative working capital is not an issue but if company is having negative working capital for an extended period of time than it needs attention as it has potential for disaster as no company can afford to have negative working capital for a long period of time.
What is Working Capital Turnover Ratio
Working capital turnover ratio is calculated as net annual sales divided by the average working capital maintained by the company during a financial year. A higher ratio implies that the company is able to use the short term capital to good effect and is a good sign, conversely, a lower ratio means that the company is not able to rotate the capital in an effective manner resulting in inefficient use of capital.
Difference between Fixed Capital and Working Capital
Fixed capital as the name suggests refers to that capital which is used by company for acquiring fixed assets like land, building, machinery and so on and that is the reason why they are financed from long term sources of finance like equity shares capital, debentures, and long term debt while working capital is that capital which is used for maintenance of fixed assets as well as in the day to day operations of the company and that is the reason why they are financed from short term sources of finance like bank overdraft, creditors and bills payable.
Difference between Gross Working Capital and Net Working Capital
Gross working capital refers to the funds which the company has invested into current assets which imply that all current like debtors, bills receivables, stocks will form a part of gross working capital while net working capital is the difference between the current assets and current liabilities of the company.
What are Advantages of Working Capital
One of the advantages of having working capital is that this capital helps in running the business smoothly because whether it’s paying to labors or paying for raw materials or making the salary payment all these expenses are met with the help of working capital. Another advantage of this capital is that it helps the company in creating goodwill in the market because companies that pay on time to other parties whether they are employees, or suppliers or anyone are always preferred and liked in the market.
What are Disadvantages of Working Capital
One of the disadvantages of having too much of working capital is the opportunity cost of capital because this capital brings no return as the primary function of this capital is to help the company in running day to day business of the company and we all know that capital is not something which comes for free or is unlimited. Another problem with this capital is that some companies tend to use this capital for long term use which creates a problem of liquidity in the company as funds are locked for the long term but liabilities have to be repaid in short term.
Idle Working Capital Ratio
The working capital ratio is calculated as current assets divided by current liabilities, a higher working capital ratio implies that the company has enough liquidity to pay its short term liabilities while a low ratio is indicative of liquidity problems. 2:1 is considered to be an ideal working capital ratio as it implies that for every one dollar of current liabilities company has 2 dollar of current assets and thus is a comfortable position as far as company is concerned, however one should keep in mind that some industries can operate on 1:1 ratio also and that is the reason why it is always advisable to compare the working capital ratio of two companies operating in same industry.
What are the Factors which affect Working Capital
Working capital is affected by many factors like the type of business as in case of manufacturing business more working capital is required as opposed to the trading business, another factor is the business environment because in times of economic growth more working capital is required to meet excess demand while in case of recession less working capital is required. Similarly, the easy availability of raw materials means the company has to stock less raw materials implying less use of working capital as opposed to that situation where raw materials are not easily available forcing the company to keep more raw materials in hand resulting in the excess requirement of working capital. Other factors like inflation, government, competitors, interest rates also affect the working capital requirement of the company.
Types of Working Capital
Working Capital is basically of 4 types, one is gross working capital which is nothing but all the current assets which can be converted into cash within a short period of time which is usually a year than second is net working capital which is the difference between current assets and current liabilities of the company, third is fixed working capital which refers to that capital which is required for proper functioning of day to day business of the company, in simple words if there is any reduction or decrease in this capital than it can put the company in trouble and create liquidity problem for the company and last is variable working capital which is required over and above the fixed working capital and is often needed when company is getting bulk orders and business of the company is booming.