Working capital is the amount of liquid assets which an organization has at hand. Working capital investments are required to pay for unexpected and planned expenses, to build a business and meet the business’s short-term duties and obligations. Working capital investment is the amount of money you require to expand your business, meet short-term business responsibilities and cover business expenses. A start-up capital, we can say, is the amount money you require to begin a business till it yields sufficient revenue so that it can pay for its own self. You can get working capital investments and start-up capital from grants, loans, partners and investors but a lot of business women put in to use their own personal resources of finance for funding their businesses.
No working capital investment would make it difficult to lure investors or even fetch credit or business loans. An organization has two types of assets which are, 1) fixed assets like machinery, property etc and, 2) current assets, which are the assets that would be used in one fiscal year. Current assets of an organization includes accounts receivable, cash at bank, cash in hand, inventory, pre-paid expenses as well as short term investments.
We can define current liabilities as those liabilities that need to be cash settled in the fiscal year. Current liabilities include the accounts payable relating to services and goods that include short term payable loans in one fiscal year. Working capital investment amount is what you get when you subtract current liabilities from the current assets. The following is the formula for deriving working capital investment:
Current Assets – Current Liabilities = Working Capital Investment
Working capital investment can be speculated as a negative or a positive number, and it depends upon the quantity of debt a business has.
How much current assets are required depend upon the nature of the business of the company, e.g., a manufacturing firm might need more stocks when compared to a firm that is in the service sector. As a company volume of output increases, the amount of current assets that are required would increase as well.
Even when you assume the procedures for debt collection, cash management and effective stock holdings, there still is a certain level of choice in the whole volume of the required current assets that are needed to meet the output demand. Policies of minimum cash holding, tight credit, low stock-holding levels etc. could be contrasted with high stock policies, sizeable cash holding and easier credit.
Working Capital Investment Requirements
Net working capital investment requirement varies from one company to another. Within the same company, the requirement of net working capital investment could vary from one month to another. The requirement of net working capital investment is dependant upon two factors:
- What are the earnings of the organization and the frequency of getting these earnings
- The expenses of the organization and how often the payments needed to be conciliated.
For knowing about calculating the working capital investment requirement needed for a new business investment, the managers need to create forecasts of earnings, which is inventory and accounts receivable and expenses, which is accounts payable. Post you have made the projections; you need to compare expenses with projections and the actual earning. Then, you have to add the raise in inventory and accounts receivable and minus from this amount, the accounts payable. The amount what you get then would show the likely change in the working capital investment that could be utilized for new investment. Any change in the working capital investment can be also determined with the outflow and inflow of funds. Thus, one should take these two things into consideration when calculating working capital investment requirements. The mathematical formula for this is:
Working Capital Investment Management
Working capital investment management is crucial to make sure that the organization has sufficient funds for carrying out its everyday operations in a smooth manner. Any business shouldn’t have a quiet a long cycle for cash conversion. Cash conversion cycle assesses the period of time for which an organization would be divested of funds in the case it raises its investments, as a procedure of its strategies for business growth. The organization needs to take some steps for the same, like reducing the customers credit period, talking terms with suppliers and raising the their period of credit with the suppliers, preserving the apt inventory level that lessens the costs of raw materials and right cash management that would ensure reduced cash holding prices. If an organization follows these measures, then the working capital investment requirement would come down automatically.
There are some other things as well which one needs to consider in relation to working capital investment requirements. If an organization’s current liabilities are more than its current assets, then it shows a deficiency in the working capital investment and might lead sometimes to a business related debt. A shortfall in working capital investment has a damaging impact on the image of an organization it shows that the firm is facing liquidity problems and is unable to pay for costs related to short term periods. In this instance, the investors might pull out of making investments of any kind in the firm. Hence, financial planning, which includes planning of working capital investment requirement is very important for running a business expeditiously.
Working Capital Investment and Over-Capitalization
In case there are inordinate cash and stocks debtors and few creditors, then there would be an excessive investment in current assets by the firm. Working capital investment would be inordinate and the firm would in this respect be over-capitalized. Return on investment (ROI) would be lesser than it actually should be as well as long term funds would unnecessarily be engaged when, instead they can be invested somewhere else to gain profits.
With respect to working capital investment, over capitalization shouldn’t exist in case the management is good but the warning since excessive working capital be poor accounting ratios. The ratios that can help in estimating if the working capital investment is reasonable or not, include:
- Working capital investment: The sales volume as a product of working capital investment ought to show weather, when compared with the former year or with similar kind of firms, the whole amount of working capital investment is very high.
- Liquidity
Ratios : A quick ratio insurplus of 1:1 or a ratio insurplus of 2:1 might indicate a more than required working capital investment.
- Turnover periods : Inordinate periods of turnover for debtors and stocks or a credit taken for a short period from supplies could indicate that the debtors’ stocks volume is high unnecessarily or the creditors’ volume is very low.