Working Capital-the buzzword for businesses
Any business organization has to resort to its 'working capital' to calculate its day-to-day running expense. Otherwise it might have to resort to loans and debt. Working Capital is the net amount of Current Assets – Current Liabilities. To run any business, your working capital must be in a positive figure so that you could meet all your current expenses and liabilities from it.
How to calculate the working capital you need?
The working capital requirement changes from business to business and industry to industry. Let us consider the simple example of a small business like a retail shop.
To run a shop, you require space for storing and displaying of the items that you would like to sell. You may have to decide upon the items that you want to trade in. You would have to determine the size of the businesses depending upon your capacity to invest. Then, you have to decide upon the method of procuring items, whether cash or credit purchases and the credit and repayment terms of trade. Similarly, you may have to sell your stock either by cash or on credit sales.
If you rent a shop space, you will have to pay monthly rent for it. You will be incurring monthly electricity bills, water charges, some stationery, etc. Further if you purchase your materials on cash you want immediate cash and for credit purchases, you want cash or funds on due dates. Similarly, if you offer credit sales, you are going to receive payments on a later period. So, you may have to make other arrangements to meet your daily expenses.
All these factors need to be taken into consideration for optimum level of working capital for your business. Accordingly, you may have to increase your stocks or decrease your liabilities and expenses.
Deciding your working capital requirement
While calculating your working capital, you should consider current assets and stocks which are easily convertible into cash. Receivables outstanding for more than six months or one year should not be taken into account for this purpose as you are not sure of their recovery to pay your immediate needs. Similarly, stocks which cannot be easily sold out in a reasonable time should be omitted from your calculation.
For liabilities, you will have to take into consideration all your liabilities and obligations required to be met within a specific period of time. When you deduct the amount of all these liabilities from the calculation of current assets amount, it will give you the margin of working capital during that specified period.
Your net working capital amount should be sufficient enough to meet any emergency requirement and any mistake in your calculation for liabilities and further, a sufficient margin should be left to enable enhancing your business activities in near future.
Your working capital level should be at equilibrium where it is not too excessive or too short for your liabilities and immediate requirement. If working capital is held much more than the required amount, there would be unnecessary lock up of your funds in current assets which do not generate any income. If you invest the same funds in other investments and shares, you could be at gain.
On the other hand, if the working capital is insufficient to meet your liabilities your business will be disturbed and you will be at loss. So maintain a good level of working capital where you could meet out all your liabilities and have some extra margin to improve your business operations.
Tips to determine and control the optimum level of working capital:
- Maintain current assets at the equilibrium level of loss that might have been incurred for carrying cost and the risk involved due to shortage cost. This is the centre point where your profit earning capacity is not obstructed due to excessive hoarding of inventory and your risk covering capacity is not overlooked due to shortage of current assets.
- Adopt selective finance techniques like temporary short-term borrowings to meet immediate shortages of working capital and switching over to long-term borrowing for liabilities to be paid over longer duration.
- Practice economic order quantity (EOQ) method of purchases. This is based on the financial principle that total cost= purchase cost + ordering cost + carrying cost. According to this principle the economic order quantity or Q= where D is the unit of annual Demand, S is the cost of placing one Single order and H is the carrying cost or Holding cost per unit.
Is there any other way to determine and calculate your working capital? Please share your views.