Working capital is considered an important metric that helps evaluate a company’s financial health. This accounting term showcases the short-term liquidity of an organisation at a point of time and assists one to determine the resources required to run the day-to-day operations of a business.
It is the difference between a company’s current assets, that include –
- Accounts receivable
- Unsold good, i.e., inventory
- Available cash with the company
-and its liabilities, that is inclusive of –
- Accounts payable
- Short-term debts
- Short-term obligations, etc.
A higher working capital turnover ratio of an organisation is indicative of its high efficiency and optimum usage of funds. While a good turnover ratio shows the proficiency of a company’s usage of short-term liabilities and assets to support their sales, it reiterates the understanding of the working capital in letting a company stay in its profit margin.
What is the relevance of working capital?
Organisations need positive working capital to meet its short-term expenses. Working capital ensures a firm’s smooth functioning and has a considerable impact on its long-term goals. Additionally, with a high working capital turnover ratio, businesses can benefit in multiple ways –
- Strengthens the solvency aspect of a business – With the presence of substantial working capital, organisations are financially covered to repay their short-term liabilities. It includes –
- Purchase of raw materials
- Recruiting skilled employees
- Payment of salary and overhead, etc.
With adequate funding via a positive working capital, entrepreneurs can maintain the solvency of their trade by offering an uninterrupted flow of production.
- Lends in a smooth supply of raw materials – The convenient and quick payment of credit purchases of raw materials leads to the regular supply from credible suppliers. With timely payment, suppliers are more than willing to ensure the frequent supply of raw materials that leads to uninterrupted production.
- Increases credibility of an organisation – A company that has adequate working capital and high solvency are deemed more credible in cases of availing financial assistance. It acts as leverage in cases of approaching lenders to avail business loans that comes with multiple lucrative features, viz. –
- High-value loan amount of up to Rs. 30 Lakh
- No collateral required
- A hassle-free loan application procedure
- Nominal documentation
Hence, considering the multiple benefits that adequate working capital brings for a company, it is ideally imperative that one has a complete understanding of how to measure its efficiency.
Which Working Capital To Choose, Net or Gross?
One must have a clear knowledge regarding net working capital and gross working capital. Especially, if you run a business you must know about these two factors of business capital. In order to let your business function properly, your business must have working capital or the much-needed fund.
Let’s talk in depth to understand the difference between net working capital and gross working capital.
First of all, the total amount of an organisation’s current assets is said to be the gross working capital. This includes the cash the business owner has, accounts receivable, short term investments made and the inventory. You cannot include the liabilities in this category.
On the other hand, the net working capital is the accurate picture of your financial status of the business. It includes the firm’s assets that it is currently holding after subtracting them from the liabilities.
Now that you know what working capital is and how it can build the future of your business, start investing in financial instruments to secure your future. Make sure you learn about various investment options so that you can see profit in the long term and short term. This ROI can be used to fund your business at the time of need.
The more working capital you have; the better the future your business holds.
How to measure the efficiency of working capital?
Measuring the efficiency of working capital reflects the credibility of a company and helps them know their presented financial standing. Here is how one can measure its efficiency –
- Inventory turnover ratio
= Sales of a company / its inventory
It gives one an idea about the sales and purchasing of a company.
- Working capital turnover ratio
= current assets / current liabilities
It gives one an idea about the adequacy of short-term assets to provide financial coverage for its short-term obligations. A ratio between 1.2 and 2.0 is considered satisfactory and showcases the measure of the positive proficiency of a company.
An adequate working capital helps your business stay agile and reflects its efficiency and. Subsequently, companies can invest considerably on their prioritised fronts.