Case Study On Types Of Working Capital
Table of Contents
Working Capital is divided into various types based balance sheet view and operating cycle view. Balance sheet view divides working capital into gross working capital and net working capital and the operating cycle view divides the working capital into permanent and temporary working capital. Permanent working capital is further divided into seasonal and special working capital whereas temporary working capital into regular and reserve working capital.
Working capital is the capital / funds required for day to day operations of the business. Working capital is invested usually in all types of inventories such as raw materials, spares, finished goods etc and credit extension to debtors and cash in hand.
Types of Working Capital
Working capital is classified into different types and the classification is based on the following views:
- Balance Sheet View
- Operating Cycle View
On the basis of Balance Sheet View, types of working capital are described below:
Gross Working Capital (GWC)
Current assets in the balance sheet of a company are known as gross working capital. Current assets are those short term assets which can be converted into cash within a period of one year. The grey area in the management of current assets or gross working capital is its unpredictability i.e. it is very difficult to ascertain the exact time of conversion of such assets. Why is such a nature problematic? It is because the liabilities occur at their time and do not wait for our current asset to realize. This mismatch or the gap creates a need for arranging working capital financing.
Net Working Capital (NWC)
Net working capital is a very frequently used term. There are two ways to understand networking capital. First, one says it is simply the difference between current assets and the current liabilities on the balance sheet of a business. The other understanding discloses little deeper or hidden meaning of the term. As per that, NWC is that part of current assets which are indirectly financed by long-term assets. Compared to gross working capital, net working capital is considered more relevant for effective working capital financing and management.
On the basis of Operating Cycle View, types of working capital are as below:
Permanent / Fixed Working Capital
Dealing with current asset and fixed assets is totally different. Determining the financing requirement in the case of fixed assets is simply the cost of the asset. Same is not true for current assets because the value of current assets is constantly changing and it is difficult to accurately forecast that value at any point of time. To simplify the complexity to some extent, on the basis of past trend and experience, we can find a level below which current asset has never gone. The current assets below this level are called permanent or fixed working capital. See the example below:
Types of Working Capital
Net Working Capital
Permanent / Fixed Working Capital
Temporary / Variable Working Capital Requirement
In the example, 2500 is the permanent working capital below which the net working capital has not gone.
- Regular Working Capital: It is the permanent working capital which is normally required in the normal course of business for the working capital cycle to flow smoothly.
- Reserve Working Capital: It is the working capital available over and above the regular working capital. It is kept for contingencies which may arise due to unexpected situations.
Temporary / Variable WC
Temporary working capital is easy to understand after getting hold over the permanent working capital. In simple terms, it is the difference between net working capital and permanent working capital. The main characteristic which can be made out of the example is “fluctuation”. The temporary working capital, therefore, cannot be forecasted. In the interest of measurability, this can be further bifurcated as below which can create at least some base to forecast.
- Seasonal Working Capital: Seasonal working capital is that temporary increase in working capital which is caused due to some relevant season for the business. It is applicable to businesses having the impact of seasons, for example, the manufacturer of sweaters for whom relevant season is the winters. Normally, their working capital requirement would increase in that season due to higher sales in that period and then go down as the collection from debtors is more than sales.
- Special Working Capital: Special working capital is that rise in the temporary working capital which occurs due to a special event which otherwise normally does not take place. It has no basis to forecast and has rare occurrence normally. For example, a country where Olympic Games are held, all the business require extra working capital due to a sudden rise in business activity.
It was all about the types of working capital. It needs to be managed with several working capital techniques so as to have the effective working capital management.Last updated on : August 31st, 2017
Working capital is a common measure of a company's liquidity, efficiency, and overall health. Because it includes cash, inventory, accounts receivable, accounts payable, the portion of debt due within one year, and other short-term accounts, a company's working capital reflects the results of a host of company activities, including inventory management, debt management, revenue collection, and payments to suppliers.
Positive working capital generally indicates that a company is able to pay off its short-term liabilities almost immediately. Negative working capital generally indicates a company is unable to do so. This is why analysts are sensitive to decreases in working capital; they suggest a company is becoming overleveraged, is struggling to maintain or grow sales, is paying bills too quickly, or is collecting receivables too slowly. Increases in working capital, on the other hand, suggest the opposite. There are several ways to evaluate a company's working capital further, including calculating the inventory-turnover ratio, the receivables ratio, days payable, the current ratio, and the quick ratio.
One of the most significant uses of working capital is inventory. The longer inventory sits on the shelf or in the warehouse, the longer the company's working capital is tied up.
When not managed carefully, businesses can grow themselves out of cash by needing more working capital to fulfill expansion plans than they can generate in their current state. This usually occurs when a company has used cash to pay for everything, rather than seeking financing that would smooth out the payments and make cash available for other uses. As a result, working capital shortages cause many businesses to fail even though they may actually turn a profit. The most efficient companies invest wisely to avoid these situations.
Analysts commonly point out that the level and timing of a company's cash flows are what really determine whether a company is able to pay its liabilities when due. The working-capital formula assumes that a company really would liquidate its current assets to pay current liabilities, which is not always realistic considering some cash is always needed to meet payroll obligations and maintain operations. Further, the working-capital formula assumes that accounts receivable are readily available for collection, which may not be the case for many companies.
It is also important to understand that the timing of asset purchases, payment and collection policies, the likelihood that a company will write off some past-due receivables, and even capital-raising efforts can generate different working capital needs for similar companies. Equally important is that working capital needs vary from industry to industry, especially considering how different industries depend on expensive equipment, use different revenue accounting methods, and approach other industry-specific matters. Finding ways to smooth out cash payments in order to keep working capital stable is particularly difficult for manufacturers and other companies that require a lot of up-front costs. For these reasons, comparison of working capital is generally most meaningful among companies within the same industry, and the definition of a "high" or "low" ratio should be made within this context.