Working Capital is a part of Short Term Financing for a firm. Basically, the difference between current assets and liabilities is known as Working Capital.
Components of Working Capital
Account Receivable: Most Companies do not expect their customers to pay for their services immediately. These unpaid bills are hence treated as an asset that can be converted into cash at a later date. The accounts receivable section is divided into 2 categories:
1.Trade Credit- This refers to unpaid bills from sales to other companies.
Consumer Credit- This refers to unpaid bills from sales to the final consumer.
2.Inventory- This refers to the raw materials, finished materials and products awaiting shipment that are yet to reach the final consumer.
Cash: The cash component is mostly stored as bank deposits. They can be in the form of demand deposits which are liquid as the company can pay them out in a short span of time. They can also be in the form of time deposits which refers to money that can be paid out after a short delay.
Marketable Securities: Commercial Paper is an important source of unsecured short term funding used by firms. The maturity of such securities is usually in a few months and they enable a firm to raise cash at a short notice at interest rates that are much lower than a bank loan.
As seen from the above data, a firm’s principal short term liability is its accounts payable to another firm. This is keeping in line with the simple rule that one firm’s credit is another firm’s debit.
Working Capital Calculation Formula:
Working Capital= Current Assets —- Current Liabilities.
The cash conversion cycle can be illustrated with an example:
Imagine a garment dealer who collects garments from various looms. He purchases processed cotton from various looms and dyes them. After dyeing, he sells the garments to garment manufacturers on credit.
If you prepare a balance sheet for this garment dealer, you will see cash at the beginning of the cycle under current assets. If you delay further, cash will give way to inventory of unfinished goods and then finished goods which are also current assets. When these goods are sold it gives way to Account Receivable which is also a Current Asset. After the customers pay their bills, the firm receives cash.
This cycle shows that though the components of Working Capital may change during the production cycle, the Net Working Capital remains the same.
Understanding Working Capital Cycle
The production cycle of a firm is a good gauge to measure its Working Capital.
1. The firm begins the production cycle by purchasing raw material. It does not pay for this raw material immediately. The delay is called ‘Accounts Payable’ period.
2. The firm processes this raw material into the finished product and puts it on sale. The period between processing the goods and putting them on sale is termed as ‘Inventory Period’.
3. The firm then receives money from customers for the goods it had put on sale. The period between putting the goods on sale and receiving money from customers is termed as “Account Receivable’ period.
Therefore, the total delay between the purchase of raw materials and the receipt of payments from customers is the sum of Inventory period and Accounts Receivable period.
The net time the firm is out of cash, is reduced by the time it takes to pay its own bills.
Cash Conversion Cycle: (Inventory Period + Account Receivable Period) – Account Payable Period.
Working Capital Gap: The longer the production process of the firm, the more cash the firm must keep tied up in inventories.
Working Capital Turnover Ratio
An important parameter to understand the utility of Working Capital is the Working Capital Turnover Ratio. This ratio presents a relationship between the money a firm uses to fund operations and the sales generated as a result of these operations. The Working Capital Turnover Ratio Is calculated as Sales/Working Capital.
Working Capital Management
The cash conversion cycle can be managed by the firm. To take an example, let’s say that the garment dealer who sells to other garment manufacturers wants to reduce his accounts receivable period. He can insist that his customers expedite his payments. To free up more cash he can also be judicious while purchasing raw material and ensure that he has no extra stock. The disadvantage of this is that he could be in a situation where he does not have enough raw materials to continue production.
Thus, a firm’s financial manager must aim to strike the right balance with regards to Working Capital.
Working Capital Loan Purpose
During the normal business cycle a firm could have a lot of its money tied up in day to day running. A Working Capital Loan is meant to offset this shortage by providing funds for the day to day running of a business. The Working Capital Loan is a form of short term finance that can be used to meet payroll requirements, recurring expenses and stocking up of inventory before a busy season.
Types of Working Capital Loan:
1. Short Term Business Loan: One can avail a short term business loan for a small amount of money to offset Working Capital needs. Depending on the credit history and reputation of the firm such a loan can even be availed collateral free. The interest rate of Working Capital loan ranges from 12-16%.
2. Line of Credit: A good credit score can enable one to obtain a Line of Credit from a financial institution. The borrower can withdraw any amount from the upper limit assigned to them by the financial institution. The advantage is that one only needs to pay back interest on the actual amount borrowed.
3. Loan on Account Receivable: A confirmed sales order value can be used to secure a Working Capital Loan. However, such a loan is only available to businesses with an established credit history.
4. Loan by a Trade Creditor: A supplier could provide a trade credit facility if one places a bulk order. Such an arrangement is often informal in nature and is one of the most popular forms of Working Capital Loan in India.
Who Can Apply For a Working Capital Loan
Documents Required for a Working Capital Loan:
1. PAN Card
2. Aadhar Card
3. Income Tax and Income Statement for Last 3 Years.
4. Audit Report and Audit Financials for last 2 years.
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