What is working capital ?
Working capital is the amount which is required for the day to day operations of the business. In other words working capital acts like blood in the human body.
Classification of Working Capital
Working capital is broadly classified into 2 ways as shown below:
Gross Working Capital
It means the firm’s investment in the total current assets. In other words gross working capital is equal to current assets of a business.
Net Working Capital
It is the difference between the current assets and the current liabilities. In other words it is the amount of working capital which has been financed through long term finance sources like investing owners funds.
Permanent Working Capital
It is the minimum amount of working capital which is required at all times for carrying out the minimum level of business activity.
Temporary Working Capital
It is the amount of working capital which is required by the business over and above the permanent working capital.
So as established above, working capital acts like blood in the human body. So as human body requires an optimum level of blood to function properly, similarly a business also requires an optimum level of working capital to function properly. There may be adverse affects if there is a paucity or excess of working capital.
If the business has less working capital to run it’s daily operations then the business might face several challenges and problems like
- Slow business development. Since there is very less working capital available, so development of business like investment in new machines or other assets may not happen and the business will remain stagnant.
- Problem in running daily operations like there will be no money to spend on administrative activities, wages of the workers, covering the utility bills etc.
- No advantage of business opportunity. If there is an opportunity to invest in new business or to in vest in research and development but the business cannot spend on these opportunity because of lack of working capital.
If the business has excess working capital, then it implies that the management is not efficient enough to use the resources judiciously. There is inefficient use of working capital. It also implies that the business has to bear the opportunity cost as the idle or excess cash could be invested elsewhere and earn business extra revenue which is not happening.
So in Working Capital Management we try to answer the following 2 questions
- How much working capital is required in the business?
- How to finance the working capital ?