Working capital is basically an amount of financial resources that the company needs to keep operating and exploring its activity. It is extremely relevant to the financial health and sustainability of the business.
It is responsible for maintaining the operations of a company, especially when the receipt of the sales or service provisions is postponed and there is no cash to cover basic expenses.
For Dolabella, one of the most well-known authors in the field, working capital is seen as follows:
These are the financial resources applied by the company in the execution of the operational cycle of its products, which will be financially recovered at the end of this cycle.
Therefore, it is what gives financial support to the company until its sales are received.
In this article, you will understand the importance of working capital for a business and its different types, and also learn how to calculate them through a simple and didactic explanation. Check it out!
The importance of working capital for companies
You have already understood that working capital is the amount of financial resources needed for the maintenance of a business. That definition is enough to show how essential it is for your company.
It is important when the company’s management wants to make an investment that will start generating returns at a future date. Thus, it will cover the existing expenses until the moment in which the invested capital can be turned into revenue for the company.
Working capital is also very important for sales or service provisions paid in installments, as the amounts in this type of operation are received only when maturity occurs.
Another important use of the working capital is related to defaulting customers. When a company has this capital backing, it can use such amount to cover sales that were made and not paid for until the settlement is carried out by the customer.
Working capital is a tool that guarantees the operation of the business, even when facing periods of scarcity of resources to maintain its basic expenses. Therefore, it is crucial that you, as an entrepreneur, know how to calculate and constitute the essential working capital for your business.
The risks of not controlling the working capital
Many entrepreneurs, even when they are aware of the importance of keeping a working capital, choose to ignore this step and not have control over these resources. In cases like these, of inefficient management, it is very likely that the company will be subject to conditions that may compromise its financial performance.
The business becomes vulnerable and at the mercy of money inflow to continue its activities. In addition, it ends up using solutions such as loans and financing from banks and other institutions to be able to pay the bills.
The main issue in all this is that the company needs to assume the costs of these services, which are generally high and accompanied by numerous fees. In the short term, the company gets the money it needs. But, in the long term, it assumes a significant debt that will keep compromising its budget for a long time.
The way you can control the working capital
For those who are not willing to face these problems and want to start getting organized as soon as possible, we will teach you how to achieve this. The first step, of course, is to learn about working capital, as this will give you a thorough understanding of the concept, the calculation and its usefulness.
Then, you need to ensure favorable internal conditions in order to have money surplus to collect the working capital needed for the maintenance of the business.
To do this, you should turn your attention to some important aspects:
- defaulting customers;
- adequacy of financial processes;
- long-term debt negotiation;
- cash flow;
- financial cycle;
- inventory management;
- reduction of costs and expenses.
If you take care of each of these items and know exactly what impact they have on the business budget, you can start to focus on the amount needed for your company to maintain a good working capital and ensure its financial health.
The option of loans and letters of credit
Of course, if you do not want to be responsible for all these control and monitoring steps or face any serious unforeseen events that affect the business’s cash flow, you can simply take the risks and resort to loans and letters of credit.
These options can become real lifelines in very specific situations. However, they are not always recommended and may be a bad strategic decision, especially if you still have time to organize the finances and make an efficient planning.
Loans and financing are granted under some strict rules and are usually accompanied by high interest rates. The big issue in all this is that the company may take a long time to be able to pay off its debts, which compromises the profitability of the business.
The difference between working capital and fixed investment
Despite having different functions and definitions, both working capital and fixed investment are concepts needed for the healthy operation of any type of company. Yet many managers still confuse them.
Fixed investment refers to the initial expenses needed for a business to operate, encompassing all the necessary goods such as equipment and machinery. Therefore, when a company is founded, one must estimate what fixed investment will be needed.
This should be one of the first steps of a business financial planning, even if the company already exists, since it is with this projection that all assets will be documented.
With this, it is possible to note the main difference between the two concepts, as the working capital is the monetary amounts in cash, in the accounts payable and receivable, in stock or in the current account; and the fixed investment is the assets. Thus, although different, the two should be together in the financial management planning of your company.
Net working capital
Going deeper into the subject, you will find the term: net working capital (NWC). This concept refers to the amount you need to fulfill all your financial commitments in the short term.
Also known as net circulating capital, this concept is used as an indicator to manage and know all the payment capabilities of the business, allowing the management of relationships with suppliers and customers.
It is known that every type of company needs resources (money) to maintain the fluidity of its activities and, consequently, to ensure that it remains active in the market. Therefore, the NWC can be considered as a financial “slack” that allows the company and its stock to operate efficiently. In order to calculate it, it is necessary to take into account the current assets (CA) and the current liabilities (CL), which are concepts that the working capital and net working capital have in common.
Own working capital
Own working capital (OWC) is defined as the variable that indicates the amount of the company’s own resources. Therefore, it will depend on the behavior of the accounts of Shareholders’ Equity and Fixed Assets.
With this concept, the amount of the company’s own capital that is completing the current and long-term assets will be revealed. However, it should be noted that it will not strictly identify all the resources of the company.
The elements of the working capital calculation
The working capital calculation is quite simple; however, it does require some level of control of your company’s finances.
You will need some essential elements of expenses and costs to determine the minimum amount of working capital for your business. For example:
- office and cleaning supplies;
- miscellaneous expenses such as water, telephone, Internet and insurance;
- tax forecasting;
- expenses with ongoing services (accounting, legal counsel, management software, etc.);
- installments of loans and financing in progress.
In summary, all expenses and costs that will happen whether or not your company receives a payment in a certain period. With this information, we will move on to the next step: the calculation.
The working capital calculation
Once all the company’s expenses have been collected, it is time to actually calculate the working capital, which is quite simple.
As an example, we will create a hypothetical situation for a service provider company that will determine the working capital needed for a specific year. From this, the following amounts of monthly expenses were calculated:
- electricity: $ 150.00;
- rent: $ 500.00;
- water, telephone and Internet: $ 250.00;
- payroll: $ 15,000.00;
- office and cleaning supplies: $ 300.00;
- tax forecasting: $ 800.00;
- expenses with ongoing services: $ 1,500.00.
Thus, the amount of working capital that this company will need to remain active is $ 18,500.00 per month.
Some companies that receive recurring payments may include such amounts in their working capital calculation in order to reduce expenses. That is, suppose that the same company receives monthly the amount of $ 5,000.00 from some customers. In that case, it may deduct the monthly payment estimate in the calculation of its working capital. Thus, the amount would be $ 13,500.00.
However, it is important that this payment is recurrent and guaranteed. You cannot consider for this calculation the payment of customers who are usually defaulters.
The net working capital calculation
The net working capital is the result of the amounts of current assets by those of current liabilities. So, to calculate it, just follow the formula: NWC = CA – CL.
Current assets refer to cash on hand, financial investments, accounts payable and receivable, stocks, expenses, raw materials, securities, bank deposits, bank transactions and prepaid expenses. Therefore, they are the assets and rights that can be converted into cash in the short term.
Current liabilities are all obligations that should normally be payable within one year, such as bank loans, debts to suppliers, provisions and certain accounts payable.
The own working capital calculation
Although it seems a bit more complex, the own working capital can be easily found with this formula: OWC = CA – CL – LTL.
LTL or Long-Term Liabilities are the debts that your company has that must be settled after the following financial year, which refers to a calendar year. Duplicates payable, taxes to be collected and other obligations to third parties are considered.
Finally, the working capital is an important indicator of your resources. With it, you will know the amount needed for your company to operate and grow in a healthy and linear manner.
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