Every business needs working capital, which is the money required to run its day-to-day operations smoothly. However, you need to understand the classification of working capital to have a clear understanding of the liquidity position of a business, short-term financial health, and operational efficiency.
Let’s explore the different classification of working capital in detail.
Classification of working capital
Working capital can be classified into various categories. Here’s a detailed breakdown:
What are the types of working capital?
Net working capital
Net working capital is the difference between a business’s current assets and liabilities. Current assets refer to accounts receivable, cash, raw materials, and inventory of finished goods. On the other hand, current liabilities refer to accounts payable. The formula for calculating net working capital is:
Net working capital = current assets – current liabilities
When a business’s current assets exceed its current liabilities, it is an indicator of a positive net working capital. But, if the valuation of current assets is less than the valuation of current liabilities, it reflects a negative working capital and poor financial health.
Gross working capital
The total value of the current assets of a business is referred to as gross working capital. These assets include cash, marketable securities such as stocks, accounts receivable, and short-term investments. The formula for calculating gross working capital is:Gross working capital = current assets
Permanent working capital
The minimum amount of money that a business needs to carry out each of its operations seamlessly without any interruption or difficulty is referred to as permanent working capital. This is in contrast to fluctuating or temporary working capital, which varies with changes in business activity.
To calculate the permanent working capital, subtract the temporary or variable working capital (current assets that vary with business activity) from the total working capital:
Permanent working capital = total working capital – temporary working capital
Variable working capital
The money that gets invested in a business for a temporary period is called variable working capital, also know as fluctuating working capital. Unlike permanent working capital, which remains relatively stable over time, variable working capital fluctuates based on factors such as seasonal variations, changes in sales volume, and business cycles.
Variable working capital = total working capital – permanent working capital
It should be noted that there are two sub-categories of variable working capital.
a. Seasonal variable working capital
Businesses that need to address seasonal demands and requirements keep a reserve of seasonal working capital. The increase in the working capital needs to be considered as temporary.
b. Special variable working capital
If there’s a temporary rise in a business’ working capital due to external factors, it’s known as special working capital. The concept behind special variable working capital revolves around urgent/emergency financial needs. Funds sanctioned to finance marketing campaigns or to deal with natural disasters/accidents fall under the category of special variable working capital.
Reserve margin working capital
Businesses must reserve a particular amount to deal with unforeseen circumstances. This reserve of extra money, which is maintained over and above the regular working capital to ensure smooth business operations, is referred to as reserve margin working capital.
Factors determining working capital requirements of a business
- Business cycle
When businesses go through the ‘high demand’ phase, they require more working capital to cater to the increased requirements. When the demand takes a dip, working capital requirements decrease considerably.
- Size and nature of business
The nature and size of a business are important factors determining working capital requirements. Companies managing large-scale operations inevitably need more working capital compared to small and medium-sized businesses.
- Seasonal fluctuations
Certain businesses face high demand during a particular season, with their inventory requirements increasing manifold during this period. To address such high demand, businesses, especially start-ups and SMEs, require additional working capital.
- Production cycle
The time difference between converting raw materials into final goods is referred to as a production cycle. If a business has a long production cycle, it will require more working capital to cater to the funding of its daily operations.
- Operational efficiency
A company’s operational efficiency depends on the production cycle, debt collection period, and time required to achieve sales. Businesses with less operational efficiency need to invest more money in working capital and vice versa.
Understanding the classification of working capital and factors determining working capital requirements helps businesses create a financial plan that helps them cater to the fluctuating demands of the market.
Remember, the sole purpose behind having working capital is not to fund daily operations and meet short-term funding requirements. It’s about planning for the long term growth and expansion of the business and ensuring an uninterrupted cash flow, irrespective of seasonal changes in demand.
How Razorpay Line of Credit can help you
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