- Working capital is the difference between the funds received from the debtors and the funds that needs to be paid to the creditors.
- It indicates the position of company’s financial health and very important for any business.
- Ideal working capital is 2:1.
- Ratio lower than 2 indicates company is not in a position to pay its creditors within one year.
- Ratio greater than 2 indicates that company is not using cash adequately in growing the business.
- Ratio between 1 and 2 indicates that company is running the business smoothly and will help in increasing the growth of the business.
- A lower working capital cycle is good for a company whereas a higher one stresses the Balance Sheet.
|Table of Contents|
|What is Working Capital?|
|Working Capital Example|
|Where do I find Working Capital?|
|Why Working Capital is Important?|
|What is Working Capital Ratio?|
|What is Working Capital Cycle?|
What is Working Capital?
In order to carry on the business, the company has to plan for future needs and also to meet its day to day expenses, such as payrolls or paying for raw material, tools and supplies. To meet these expenses company requires cash.
Therefore, the funds that is required by a company to meet its short term expenses (within 1 year) is known as ‘Working Capital’.
It represents the cash required to meet the company’s short term expenses.
Working Capital Example:
Suppose you have a company name RICA ltd.
It is a company manufacturing pens. Hence, requires cash to pay to its raw material suppliers who gives credit to the company for 3-4 months.
Company also receives cash by selling pens to its customers and retailers.
So, company will calculate the difference between cash that is being received and payments that needs to be done. This difference is known as Working Capital.
In, accounting terms it is the difference between Current Asset and Current Liability (they stand in the books for a year only).
Current Asset refers to cash that is readily available to the company and other assets that can easily be converted into cash within one year.
Current Liabilities refers to the amount which is to be paid off within one year.
Where do I find Working Capital?
Since, working capital is the difference between Current asset and current liability it is not shown in the Balance Sheet.
Instead you can find Working capital in the Cash Flow Statement.
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Why Working Capital is Important?
Working Capital is very important for any company as it indicates company’s financial health. It indicates whether Company is in a position to meet its short term expenses or not.
It helps to maintain smooth operation of the business and helps in improving profitability and earnings. Using a forecasting tool can help your team maximize revenue throughout the sales-to-revenue process which will have a direct impact on working capital as the month progresses.
Investor, Business owners and accountant uses working capital ratio to get an idea of company’s Liquidity position.
What is Working Capital Ratio?
Working capital ratio indicates readily available cash with the Company. A ratio between 1.2 to 2 is considered to be a healthy working ratio.
A company having a working capital ratio less than 1 may not be good as it indicates poor cash flow of the company.
This is calculated by dividing Current Assets by Current Liabilities. Most often this ratio is calculated at year-end when annual reports are available.
WORKING CAPITAL RATIO: – CURRENT ASSETS/CURRENT LIABILITIES
A ratio less than 1 indicates that the company is having a shortage of cash which may not be good for any company as it increases liquidity risk and increases the possibility of higher short term debt which comes at a higher rate of Interest and thus impacts overall profitability.
Let us understand this with an example:
FY19 In Crs
CURRENT ASSETS 758
CURRENT LIABILITIES 789
WORKING CAPITAL RATIO 0.96
As of march FY19, current assets are Rs.758 cr and current liabilities are Rs. 789 cr.This means that current liabilities are higher than current assets and the working capital ratio is also less than 1.
This gives a negative feedback of the company’s liquidity position.
Since the ratio is lower as current liabilities are more so the company has to borrow more funds to run the day to day business of the company. This will in return hamper profitability.
So the alternate method to raise funds for running the daily business of a company can bring in some discounts on products or generate cash by giving some offer to the clients.
Basically company needs to increase the sale in order to get cash so that the company can meet the working capital demand internally but this can hamper the topline as the company might have to resort to lower margin selling.
Thus, higher working capital is good for the company. It shows that the company is in a position to pay its debt and to all its creditors within 1 year maintaining enough liquidity.
Let us understand this with an example:
Company:-Nestle India Ltd.
FY19 In Crs
CURRENT ASSETS 3817
CURRENT LIABILITIES 2148
Working Capital Ratio 1.7
The company has working capital ratio of 1.7 which is a good one.
As this lies between the ideal ratio 1.2 to 2. This shows that company is in a position to pay its creditors and foot its bills within one year.
Company needs to manage its working Capital ratio.
As ratio above 2 is also not good. It means that the company has lots of cash piled up and not using it for growing of the business.
A lower/or decreasing working capital ratio shows that company is having shortage of cash and is unable to pay its creditors on time, This may lead to increase in short term loans for the company.
A very high or ratio above 2 is also not good for the company as it also gives negative impact of the company.
Company should maintain its Working Capital ratio between 1.2 to 2 which is best for any company as it shows that company is running its business smoothly.
Now for any company to run smoothly we should not only know the Working Capital ratio but also know the Working Capital Cycle
What is Working Capital Cycle?
Every company has to go through a cycle from raw material procurement to production to distribution and then to sales. Thus this process takes time. Thus money so invested into the business takes time to come back to the company. This entire process is known as working capital cycle. It means how many days, a company takes to realize its sales value back.
It is calculated by Adding Inventory days and Receivable days and from it subtracting the Payable days.
Working Capital Days:
For example if a company takes 5 days to turn its Inventory into a product and gets its money back from sales in 15 days and makes payment to its raw material suppliers in 10 days then the number of days that the money comes back to the company is 5+15-10. Which means the money is rotated back into the business in 10 days.
Thus a lower working capital cycle is good for a company as the liquidity for running the business remains intact, whereas a higher working capital cycle stresses the Balance Sheet of a company and also affects its Liquidity.
A higher working capital cycle may push the company for taking short term loans to fund its working requirement and a short term loan generally comes at a higher rate of Interest.
Thus invest into companies with lower working capital cycle if all other metrics are strong.