Working capital is a very essential capital that is obligatory for every business regardless of the size and nature of the business. Without the working capital, no business can function properly. A business should always try to manage its working capital to run the business successfully without experiencing any financial hassles.
Working capital management is a business tactic that benefits the business in using the current assets effectively to maintain suitable cash flow to meet short-term aims and other necessities. This guide will give you detailed knowledge regarding various types of working capital and why they are important for a business.
What is working capital?
First, let us understand what the working capital is. Working capital, which is also known as net-working capital, is the difference between the current assets and the current liabilities of a company.
- Current assets comprise cash, accounts receivables which are the unpaid bills by the customers, and inventories of raw materials and finished goods.
- Whereas the company’ will include accounts payable, wages, taxes payable, and even the current portion of long-term debt.
By checking the working capital of a company, we can identify how well the company is working and how they are managing the working capital to meet the day-to-day activities.
To find the working capital of a company there is a formula that is being used by all. That formula is given below.
Working Capital – Current Assets – Current Liabilities
8 Types of working capital
Working capital is of different types and these are classified based on periodicity and concept. Let us learn a little more about 8 different types of working capital in this section.
1. Permanent Working Capital
This type of working capital will remain permanently with the current assets. It is tied up with current assets to manage the activities of a business successively. Since the permanent capital is the least amount of current assets that are required to run the business easily, it is also known as fixed working capital. Depending on the size and business growth, the amount of permanent working capital required will diversify. The fixed or permanent working capital is subdivided into two different categories which can be seen below.
2. Regular Working Capital
Regular working capital is the least amount of capital which is required for a business to spend for day-to-day operations. Examples of regular working capital are payment required for salaries and wages, overhead expenses for processing the raw materials for the company, etc.
3. Reserve Margin Working Capital
Any kind of business will always need some amount of capital for unexpected situations other than the amount used to perform daily operations. Thus, the reserve margin working capital is set aside which can be used during certain circumstances that can occur out of nowhere. Such incidents can be like a strike, natural calamities, etc when the reserve margin working capital will be used.
4. Variable Working Capital
Variable working capital is the fund that is invested in the business for a temporary period. This category of working capital is also identified as fluctuating working capital and can vary according to the size of the business or when there is a change in the assets of the business. Variable working capital is again subdivided into two other categories which can be seen below.
5. Seasonal Variable Working Capital
The business requires this kind of working capital during the peak season of the year. Hence it is known as seasonal variable working capital. Businesses that are into production and manufacturing of various kinds of products and services will have seasonal demand and to maintain such demand for the products the seasonal variable working capital is created.
6. Special Variable Working Capital
Running a business is not easy. A businessperson might have to face many unforeseen situations and undertake such kinds of exceptional operations, a particular amount of working capital will be required. Such supplementary working capital is the special variable working capital that is necessary to use in unanticipated situations. Examples include funds needed for marketing campaigns, unexpected events like accidental fire, flood, and other kinds of natural calamities, etc.
7. Gross Working Capital
Gross working capital is the type of working capital that is the aggregate amount of funds invested in a business’s current assets. In other words, we can say that gross working capital is the total of the current assets of the business which will include cash, accounts receivables, inventory, marketable securities, and even short-term investments.
Gross Working Capital, if used alone will not display the complete image of the short-term financial reliability. Likewise, it does not showcase the operational proficiency of the business. To better understand the operational efficiency of a business, the current assets should be compared with the current liabilities. The result will show how efficiently a business uses its short-term assets to meet its day-to-day cash necessities.
8. Net Working Capital
The last type of working capital is the net working capital which is the amount that arises when the current assets of the business exceed the current liabilities. This is why the working capital formula is defined as the difference between the current assets and the business’s current liabilities. The sum of working capital a business has showcases the operational efficiency, liquidity, and short-term financial capacity of the business.
Every business that has enough working capital to meet all the requirements will have the capability to invest and grow in the future. Whereas, a business that does not have sufficient working capital will not be able to pay for their short-term commitments which will abstain them from growing and may experience bankruptcy too.
FAQs related to types of working capital
- What are the factors that determine the working capital of a business?
The working capital need of a business depends on the nature and size of the business, the business cycle, production cycle, operational efficiency, and seasonal fluctuations.
- Give an example of working capital.
Consider ABC as a business entity. When the ABC Company started initially, they had working capital of only INR 10,000. Their current assets were averaging at INR 50,000 and current liabilities averaging INR 40,000. To increase its working capital, ABC decided to keep more cash in reserve which they did by delaying its payments to suppliers intentionally, so that its current liabilities will reduce. When ABC made these changes, its current assets came to INR 70,000 and current liabilities became INR 30,000. So the working capital of ABC Company will be INR 40,000.
- How can a business arrange working capital?
To arrange the working capital, a business can utilize invoice finance, business loans, trade credit, line of credit, etc.
- How can a company increase its working capital?
Any company can increase its working capital by making more revenue, selling long-term assets, and issuing preferred stock.
- What is the meaning of the working capital cycle?
The working capital cycle is the measurement of how punctually a business can convert its current assets into cash or equivalent to cash. This will help small and medium-sized enterprises manage their cash flow and enhance their efficiency in operations.