Working capital is an essential financial component of any business. It represents the funds available for day-to-day operations and ensures smooth business functioning. Proper management of working capital helps businesses maintain liquidity, meet short-term obligations, and sustain growth.
This article explores the meaning, definitions, types, and importance of working capital, along with its calculation and impact on business operations.
Meaning and Definition of Working Capital
In simple terms, working capital refers to the capital invested in current assets, which are assets that can be converted into cash within a short period, typically one year. These include raw materials, semi-finished goods, finished goods, accounts receivable, and cash.
Various finance experts have defined working capital as follows:
- According to Gastenberg:
“The current assets of a business, which change from one form to another, are known as working capital. Working capital is the capital that floats and circulates inside and outside the business.”- This definition highlights the dynamic nature of working capital, which continuously moves through different forms in business operations.
- According to Hoagland:
“Working capital is a description of capital, which is not permanent, but the common use of working capital is to mean the difference arising from the book value of current assets minus current liabilities.”- This definition introduces the concept of net working capital, which is the difference between current assets and current liabilities.
- According to John Stuart Mill:
“The sum of current assets is the total working capital of a business.”- This interpretation defines gross working capital, which includes all current assets of a business.
Types of Working Capital
Working capital can be categorized into two main types:
1. Gross Working Capital
Gross working capital refers to the total amount of current assets a business owns. It includes:
- Stock of raw materials and finished goods
- Accounts receivable (debtors)
- Spare parts
- Cash on hand and in the bank
- Non-commercial short-term investments
- Expenses paid in advance
2. Net Working Capital
Net working capital is calculated as: Net Working Capital=Current Assets−Current Liabilities\text{Net Working Capital} = \text{Current Assets} – \text{Current Liabilities}Net Working Capital=Current Assets−Current Liabilities
Current liabilities include:
- Creditors (accounts payable)
- Bank overdrafts
- Short-term loans
- Public deposits
- Outstanding expenses
- Tax provisions
- Proposed dividends
- Unpaid dividends
Difference Between Gross and Net Working Capital
| Gross Working Capital | Net Working Capital |
|---|
| 1. Mr. Baker refers to working capital as “Total Working Capital.” | 1. Sir Lincoln and Stevens define working capital as “Net Working Capital.” |
| 2. Formula: Total Working Capital = Total Current Assets | 2. Formula: Net Working Capital = Current Assets – Current Liabilities |
| 3. Effect of Loans: Short-term loans increase total working capital. For example, if cash is introduced into the business by taking a loan or if the bank balance increases due to a bank overdraft, total working capital also increases. | 3. Effect of Loans: Taking loans or incurring short-term liabilities does not increase net working capital. |
| 4. Financial Condition: It does not provide a true picture of a business’s financial condition, as it only considers total assets. | 4. Financial Condition: It provides a realistic view of the business’s financial position by subtracting current liabilities from current assets. |
| 5. Nature of Measurement: This is a liberal method of measuring working capital. | 5. Nature of Measurement: This method provides a true and accurate measure of working capital. It is suitable for businesses where ownership and management are the same, such as sole proprietorships and partnership firms. |
Importance of Working Capital
- Ensures Liquidity – Sufficient working capital ensures that a business can meet its short-term obligations and avoid financial crises.
- Smooth Business Operations – A positive working capital helps maintain uninterrupted production and service delivery.
- Financial Stability – Proper working capital management strengthens the financial health of a company, making it attractive to investors and creditors.
- Growth and Expansion – Businesses with adequate working capital can expand operations, purchase raw materials in bulk, and invest in new opportunities.
- Creditworthiness – A strong working capital position increases a company’s ability to secure loans and attract investment.