Working Capital: Meaning, Importance and Types

Working capital is an indicator of the short-term financial position that measures the overall efficiency of an organization. It is calculated by subtracting current liabilities from current assets and listed directly in its balance sheet.
Current assets mean the money kept in a bank and assets that can be converted into cash in case if any situation arises. Current liabilities represent debt that an individual will pay within the prescribed year. Finally, working capital is the money left after subtracting liabilities from an individual's money in the bank.
Current assets consist of cash, accounts receivable, and inventory. Current liabilities include wages, taxes, interest owed.
In broader terms, working capital is also used to measure the company’s financial health. If there is a larger difference between what a company owns and what an individual owns for the short-term, the business will be healthier.
If the company owes more than they own, they will have negative working capital, and their business might get closed.

The sole purpose of using working capital is to fund operations, meet the short-term obligation, and continue to have sufficient working capital. It’s continuously paying its employees and suppliers to meet other obligations like taxes and interest payments even if they have any cash flow challenges.
Working capital is also used to fuel business growth without incurring debt. If the company does not want to take a loan, they can qualify easily for loans or other forms of credit because of their positive working capital.
Several financial teams have mainly two goals in their mind:
1) To have a clear goal and view of how much cash is on hand at any given time
2) To work with multiple businesses and to maintain enough working capital to cover liabilities.

The types of working capital are mainly divided into different parts:

• Gross Working Capital

Gross working capital is the total value of the company’s current assets. Current assets include cash, receivables, short-term investments, and especially market securities.
The Gross working capital does not showcase the current liabilities. Gross working capital can be executed by calculating the difference between the existing assets and current liabilities.
The difference remaining is the actual working capital that the company has to meet its obligations.

• Net Working Capital

Networking capital is the difference between the current assets and current liabilities of the company. If the company’s assets are more than current liabilities, it indicates a positive working capital, and the company is in a financial position to meet its obligations.
However, if the company’s assets are less than current liabilities, it indicates a negative working capital, and the company is facing financial distress.
The key difference between gross and net working capital is that gross working capital will always be a positive value. In contrast, networking capital can either be a negative or positive value.

• Permanent Working Capital

Permanent working capital is the minimum amount of capital required to carry on the operations without interruption or difficulty.
For example, a company will need minimum cash to keep the operations smooth and running; here, the minimum amount of money required will act as permanent working capital.

• Regular Working Capital

Regular working capital is the amount of funds businesses require to fund its day to day operations. For example, cash needed for making payment of wages, raw materials, salaries comes under regular working capital.

• Reserve Margin Working Capital

Apart from conducting day-to-day activities, a business may need some amount of capital to face unforeseen circumstances. Reserve margin working capital is nothing, but the money kept aside apart from the regular working capital. These funds are held separately against unexpected events like floods, natural calamities, storms, etc.

• Variable Working Capital

Variable working capital can be defined as the capital invested for a temporary period in the business. Variable working capital is also called fluctuating working capital.
Such capital differs with respect to changes in the business assets or the size of the business. Furthermore, variable capital is subdivided into two parts:

1) Seasonable Variable Working Capital
Seasonable variable working capital is the amount of capital kept aside to meet the seasonal demand if the business is running seasonally.

2) Special Variable Working Capital
Special variable working capital is the temporary rise in the working capital due to any unforeseen or occurrence of a special event.

If the company has low working capital, it means that it is dealing with low current assets and more current liabilities. On the other hand, a low net capital does not indicate that company is dealing with losses.
Working capital reflects short-term financial health and lower financial health means the company has invested major chunks of money into something that may give higher returns to them.
If a company has completed its financial obligations with insufficient working capital, it means that it is reliable and can manage finance optimally.
Negative working capital means the current assets are less than current liabilities, and it can even lead to bankruptcy if it is continued for several months or years.

• What is net working capital?

Networking capital is the difference between the current assets and current liabilities of the company. If the company’s assets are more than current liabilities, it indicates a positive working capital, and the company is in a financial position to meet its obligations.

• What is the difference between gross and net working capital?

The key difference between gross and net working capital is that gross working capital will always be a positive value. In contrast, networking capital can either be a negative or positive value.

• What is the sole purpose of using working capital?

The sole purpose of using working capital is to fund operations, meet the short-term obligation, and continue to have sufficient working capital. It’s continuously paying its employees and suppliers to meet other obligations like taxes and interest payments even if they have any cash flow challenges.