Working Capital Definition, Types, Ratio and Cycle 

Working capital is a sign of the short-term financial status of a firm, and at the same, this reflects the overall efficiency of the company. It is calculated by subtracting the present liabilities from the current assets. The result indicates whether the firm has sufficient assets to overcome its short-term debt.

Working capital shows the liquidity levels of firms for carrying daily expenses and cover cash, inventory, accounts payable, short-term debt (which are due) and the receivable accounts. It is derived from various firms operations such as inventory management, debt, collection of revenues and supplier payments.

Sources of Working Capital

The sources of capital can either be spontaneous or short term and long term.

Spontaneous it is mainly derived from credit trade, including payable notes and payable bills.

Short-term working capital includes sources such as tax provisions, dividends, public deposits, short-term loans, cash credit, trade deposits, inter-corporate loans, bills discounting and also financial paper.

The long-term working capital sources include provision for depreciation, long-term loans, retained profits, share capital and debentures. There are large sources of working capital for firms based on their day-to-day requirements.

Different Types of Working Capital?

There are different types, depends on the operating cycle point or the balance sheet.

The balance sheet aspect classifies capital into two types:

1) Gross– It includes present securities in the balance sheet.

2) Networking– It includes the difference between the current liabilities and current assets in the balance sheet of the respective company.

On the other hand, according to the operating cycle aspect, the capital is classified into:

1) Temporary– It is the difference between permanent and net working capital. It is bifurcated further into two types:

a) Regular working capital

b) Reserve working capital

They both depend on the chosen aspect.

2) Permanent working capital– It includes the fixed assets capital of a firm.

Understanding The Working Capital Cycle

The WCC means the time interval that is required to convert net current assets and liabilities into cash by any firm. It indicated the efficiency of the organization in terms of efficient managing liquidity level in the short-term or definite cycle (calculated in days). It is generally an interval between the production of revenue by selling items (through cash) and the purchasing of raw materials for manufacturing these products.

The shorter the value of this capital cycle, the smoother will the firm be able to free up its money (particularly blocked money). If the process is long, the money generally gets held without generating returns or profit in the operational cycle. Companies always try to lower its value for enhancing the short-term liquidity of its business.

Formula For Evaluation

The formula for calculating aggregate is as follow:

Working capital = currently available assets – current Liabilities

The ratio is a sign of whether a firm has sufficient short-term assets to fulfil the short-term debt possessed on them.

  • If the value of ration is lower than 1, then it indicates the negative value of it.
  • If the ratio is between the mark 1.2 and 2.0, then it indicates a sufficient/positive value of it.
  • If a value exceeds 2, it indicated there are surplus assets with the company which it is not willing to invest, and therefore this represents the condition of missed opportunity.

The company face trouble in case its current assets do not surpass the present liabilities. When it comes to resolving obligations, the cash which is stuck or locked in the financial market, inventory (which the consumer has not paid yet), is not regarded as viable.

The variation affects a firm’s cash flow.

Most big fresh projects, such as an increase in the production or into the new commercial market, need investment in it. It mitigates cash flow. The cash will also reduce in case the money is gathered too slowly, or if the volume of sales is decreasing. Thus it results in the decreasing of receivable accounts. Firms that are inefficiently utilizing the working capital can enhance cash flow rates by minimizing the customers and suppliers.

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