Definition Of Business And Working Capital

Published Date: 02 Nov 2017

Working capital is a financial element which represents and referring to the operating liquidity available to an organization, business or other entity, including governmental entity. Working capital is considered a part of operating capital along with fixed assets such as equipment and plants. Other than gross working capital that will be explained later, net working capital is calculated and refers as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows). An entity has a working capital deficiency or also called a working capital deficit if current assets are less than current liabilities.

Working capital in other definition state that as the amount of money a company has on hand or will gain in a given year. Working capital is calculated by subtracting current liabilities from current assets. That is, one takes the value of all debts and obligations for the current year and subtracts that from the value of all cash and assets that might reasonably be converted into cash in the current year. This is a good measure of the short and medium-term financial health of a company, and may indicate by how much it can expand its operations without resorting to borrowing or another capital raising tactic. Working capital is also called operating assets or net current assets.  Working capital is the money that allows a corporation to function by providing cash to pay the bills and keep operations humming. One way to evaluate working capital is the extent to which current assets, which can be readily turned into cash, exceed current liabilities, which must be paid within one year. Some working capital is provided by earnings, but corporations can also get infusions of working capital by borrowing money, issuing bonds, and selling stock.

Other than that, working capital is also defined as how much in liquid assets that a company has on hand. Working capital is said needed to pay for planned and unexpected expenses, in the case that the company will meet the short-term obligations of the business, and to build the business. It will be hard to attract or to get investors and getting business loans or obtain credit if the company is lacking of working capital.

So, when first start a business it is needed to start-up working capital since the business is not making money to sustain itself yet. Due to a lack of working capital, it becomes the first reason that making most businesses fail during their first two years of operation. Having ample working capital not only helps you to meet your obligations, it is vital to growing your business.

A company can be rich with assets and profitability but will suffer short of liquidity if its assets cannot be converted into cash readily. To ensure that a firm is able to continue its operations and has sufficient funds to satisfy both maturing short-term liabilities and upcoming operational expenses a positive working capital is required. The management of working capital involves managing cash, inventories, account receivable and account payable.

Working capital management is the study with the problems that arise in attempting to manage the current liabilities, the current asset and the relationship that existed between them. Current liabilities are liabilities which are intended, in the definition refer to be paid in the ordinary course of business, within a year, out of the current assets or earnings of the concern. Accounts payable, bills payable, bank overdraft, and outstanding expenses are the basic current liabilities. Current assets refer to any assets involve which in the ordinary course of business can be, or will be, converted into cash within one year without undergoing a depreciation in value and without disrupting and disturbing the operations of the firm. Inventory, marketable securities, accounts receivable and cash are the major current asset. The objective and aim of working capital management is to manage the firm’s currents assets and liabilities in such a way that a satisfactory level of working capital is maintained. This is because it will become insolvent and even be forced into bankruptcy if the firm cannot maintain a satisfactory level of working capital.

There are two concept of working capital, they are gross and net. The term gross working capital is referring to the total current assets. The term net working capital are defined in two ways which are the difference between current assets and current liabilities and the second one is alternate definition of net working capital (financed with long-term funds). To ensure sufficient liquidity in the operations of the enterprise is the role of the financial manager in managing working capital efficiently. The liquidity of a business firm is measured by its ability to satisfy short-term obligations as they become due.

It may run into trouble paying back creditors in the short term if a company's current assets do not exceed its current liabilities. The worst-case scenario and worst part is bankruptcy. A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis that is for example as a result that the company's sales volumes are decreasing, its accounts receivables number continues to get smaller and smaller. Working capital also gives investors an idea of the company's underlying operational efficiency. Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company's obligations. So, if a company is not operating in the most efficient manner it will show up as an increase in the working capital. This can be seen by comparing the working capital from one period to another; slow collection may signal an underlying problem in the company's operations. 

There is also article that explained how it comes to negative working capital. The negative working capital state where a company is basically operating and working with no capital because the company's liabilities exceed and larger than  the available assets. If the additional funds are not acquired, the company will be unable to meet payment requirements on certain liabilities and a company cannot operate with negative working capital for an extended period of time. By comparing and looking at the accounts receivable information and accounts payable information, a company can quickly identify this state.

There is much condition that bring to negative working capital for example, if the total of marketable securities, cash, notes receivable and accounts receivable, inventory, and other current assets is less than the total of accounts payable, short-term notes payable, long-term debt, and other current liabilities, the firm has a negative working capital. The firm will not be able to pay debts when due, resulting in bankruptcy and threatening its ability to keep operating and possibly unless the condition is corrected. To remedy a negative working capital position, a firm has a few alternatives. First, it can convert a long-term asset into a current asset for example, by selling a piece of equipment or a building, by liquidating a long-term investment, or by renegotiating a long-term loan receivable. Other than that, it can convert short-term liabilities into long-term liabilities for example, by negotiating the substitution of a current account payable with a long-term note payable. It can also borrow long term debt. Fourth, it can obtain additional equity through a stock issue or other sources of paid-in capital. Lastly, it can retain profits. 

The working capital can be classified on the basis of concept and on the basis of time. Generally there are two concepts of working capital. They are gross working capital and net working capital. But they are defined by different names.

In broad sense, working capital refers to gross working capital. It is also defined as financial concept or going concern concept. It means the capital invested in the current assets of the firm. Current assets mean the assets which can be converted into cash easily or within one accounting period. It helps in determining the return on investment in working capital and providing correct amount of working capital at right time.

  In narrow sense: working capital refers to net working capital. It is also defined as accounting concept. It means excess of current assets over current liabilities. It helps in finding out firm’s capability to meet short term liabilities as well as indicates the financial soundness of the enterprise. Net working capital equal to current assets minus current liabilities.

  Net working capital can be positive or negative. When current assets are more than the current liabilities than working capital is positive and when current assets are less than the current liabilities than working capital is negative. At the end we can say, that both the working capital are important but according to the suitability gross working capital is suitable for companies having separate ownership or management while net working capital is suitable for sole trader companies or partnership firms.

Types of working capital on the basis of time are permanent working capital where it is also called fixed working capital. It means to carry on the day to day expenses the firm is required to maintain the minimum amount of working capital. For example the firm is required to maintain the minimum level of raw material, finished goods or cash balance.

Other than that, regular working capital where it means the minimum amount which the firm has to keep with itself to carry on the day to day operation. Reserve working capital where it means the excess amount over the regular working capital for uncertain circumstances like strike, lock out, depression. Temporary working capital which it is also called variable working capital, which is required to meet the seasonal demands as well as for special purposes. Seasonal working capital means it is required to meet the seasonal needs of the enterprise. Special working capital which means it is required for some special purposes of the enterprise for example advertising the product of the firm requires special working capital. Temporary working capital is for short period and fluctuates while permanent working capital is stable and fixed.

BENEFITS AND ADVANTAGES

The first advantage of working capital is being able to detect any financial difficulties that may arise. Even a business that has billions of dollars in fixed assets will quickly find itself in bankruptcy court if it can't pay its monthly bills. Under the best circumstances, poor working capital leads to financial pressure on a company, increased borrowing, and late payments to creditor that all of which result in a lower credit rating. A lower credit rating means banks charge a higher interest rate, which can cost a corporation a lot of money over time.

Other than that, companies that have high inventory turns and do business on a cash basis need very little working capital. These types of businesses raise money every time they open their doors, then turn around give that money back into inventory to increase sales. Since cash is generated so quickly, managements can simply stock pile the proceeds from their daily sales for a short period of time if a financial crisis arises. Since cash can be raised so quickly, there is no need to have a large amount of working capital available.

A company that makes heavy machinery is a completely different story because these types of businesses are selling expensive items on a long-term payment basis, they can't raise cash as quickly. Since the inventory on their balance sheet is normally ordered months in advance, it can rarely be sold fast enough to raise money for short-term financial crises (by the time it is sold, it may be too late). It's easy to see why companies such as this must keep enough working capital on hand to get through any unforeseen difficulties

It reveals more about the financial condition of a business than almost any other calculation. It tells you what would be left if a company raised all of its short term resources, and used them to pay off its short term liabilities. The more working capital, the less financial strain a company experiences. By studying a company's position, you can clearly see if it has the resources necessary to expand internally or if it will have to turn to a bank and take on debt.

Moreover, by working capital a company can pay their suppliers, pay their staff, and pay them a wage, and can expand their business. It also gives a company the ability to meet its current liabilities, expand its volume of business and take advantage of financial opportunities as they arise.

Other article state that the advantages of adequate working capital are helps in maintaining goodwill of the firm, helps in maintaining solvency of the firm, helps the firm in getting regular supply if raw material, helps the firm in getting regular return on investment, helps the firm in getting payment, helps the firm to face the crisis, helps the firm in getting loan easily from the banks and helps the firm in getting cash discount.

Working capital consists of the excess of the company's current assets over the company's current liabilities. Current assets represent everything the company owns that it expects to convert into cash or use the benefit of within one year, such as accounts receivable, inventory and prepaid insurance. Current liabilities represent everything the company owes that it expects to pay within one year, such as accounts payable, wages payable or subscriptions payable.

When a company uses working capital to finance its business operations, it converts the current assets into cash or exchanges ownership of the current assets for cash. The business might sell inventory or accounts receivable accounts, for example. The company then uses the cash received to finance the company's activities. This allows the business owners to retain their current level of ownership. Other forms of financing, such as issuing stock or acquiring partners, increases the number of owners and reduces the ownership percentage of the current owners.

After converting working capital into cash, the company is free to use the funds. The company incurs no additional financial burden through this method of financing. It simply uses the cash it currently has. By using working capital to finance the business activities, the company pays no interest on the funds. Other financing options, such as borrowing from the bank or issuing bonds, require the company to make regular interest payments.

A company who uses its own working capital to finance the business operations maintains the pride of being self reliant. For many entrepreneurs, the desire to build the business on their own merit ranks higher than advancing the business at other costs. This company strives to increase its working capital to a sufficient level prior to expanding its business.

DISADVANTAGES OF WORKING CAPITAL

There is also a few of disadvantages and weakness in working capital that are a company cannot expand, cannot pay their staff, cannot pay themselves, and cannot pay their suppliers. So in a nutshell no cash flow or working capital and no viable business. Other than that lack of sufficient working capital and inability to liquidate current assets are frequent causes of business failure. It also leads to excessive debtors, spare funds are of no use and earn no profit, and firm fails to maintain the relationship with the banks due to non requirement of funds and lastly, leads to unnecessary purchasing.