Working capital is one of the vital resources required by a company to carry on its operations and requires planning, forecasting, and understanding of various aspects of the business. Estimation of working capital is gaining importance these days as it is imperative for profitability, growth, and survival of the business.
Working capital can be estimated in the following manner:-
- Gross working capital: The working capital is the sum total of all the current assets of the business.
- Net working capital: The working capital is the difference between current assets such as cash, Receivables, Inventory, etc, and current liabilities like payables.
- Operating cycle: It is the time period between payment to suppliers for goods and receipt of cash from receivables. The longer the cycle, more is the working capital required
1 & 2 above are also known as the Balance sheet method of working capital estimation.
For optimum usage of working capital, the company has to manage the following components efficiently;
1. Cash - Avoid holding too much cash leading to loss of interest or invest in securities that may not be liquid. Cash requirements should be estimated with help of cash budgets.
2. Debtors/Receivables - Credit analysis, discount decision, optimum credit period, proper recovery procedures, factoring help to reduce costs associated with receivables.
3. Inventory - Maintain optimum levels of inventory and strike a balance between storage costs and transaction costs to avoid too much capital being tied up in inventory or stock out situation.
4. Creditors/ Payables - Negotiation of credit period, evaluation of cash discounts, etc help to regulate the payables.
The above measures are commonly followed however, it may be modified based on the nature of the business and the industry in which it operates.
The working capital ratio is also a good measure to evaluate the liquidity position of the business. It is calculated by dividing the Current assets by current liabilities and as a standard, the ratio >1 denotes positive working capital.
High levels of working capital may indicate high levels of inventory/receivables and low levels may indicate risk to the business. Hence, it is imperative to estimate the optimum level of working capital for every business considering the needs of the business and industry average.