Working Capital | Meaning, Formula and Types

What is Working Capital ?

Excess of current assets of an organisation over its current liabilities is known as Working Capital. Simply put, it is the finance available to an organisation for its day-to-day business operations. It can also be defined as that part of total capital, which is required for holding current assets. Current Assets and Current Liabilities of an organisation determine its working capital.

Current Assets are the assets, which can be converted into cash and cash equivalents within a period of one year. Investment in these assets helps an organisation in its day-to-day operations. They also provide liquidity to the business but do not contribute much to its profits. Therefore, an organisation has to maintain a balance between liquidity and profitability. For example, cash in hand, debtors, bills receivables, etc.

Current Liabilities are the liabilities of a firm which are payable within a period of one year. For example, creditors, bills payable, advance received, outstanding expenses, etc. 

Types of Working Capital

Working Capital can be of two types:

1. Gross Working Capital

The investment in all the current assets, like prepaid expenses, cash, inventories, bills receivables, etc., is known as Gross Working Capital. The gross working capital of an organisation gets converted into cash within an accounting year.

The list of current assets in order of their liquidity is as follows:

• Cash in hand/Cash at bank
• Debtors
• Marketable Securities
• Finished goods inventory
• Bills Receivable
• Work in progress
• Raw Materials
• Prepaid Expense

Formula:

Gross Working Capital = Sum total of all Current Assets

2. Net Working Capital/Working Capital

Excess of current assets over current liabilities is known as Net Working Capital. Current liabilities are a source of funds for acquiring current assets and are to be paid within an accounting year. For example. Tanya gets credit for maintaining stock. Now, the stock (which is a current asset) is created by her through credit purchase (which is her current liability). When the current liabilities of an organisation exceed its current assets, then the net working capital of the firm will be negative. The net working capital of an organisation depicts its liquidity position. The negative net working capital of an organisation indicates a poor and weak liquidity position; however, a positive net working capital indicates a positive liquidity position.

Formula:

Net Working Capital = Current Assets – Current Liabilities

Example:

Gross Working Capital is different from Net Working Capital. It can be proved with the help of the following example:

Let’s say, the Current Assets of an organisation are as follows:

Cash = ₹60,000

Debtors = ₹90,000

Inventory = ₹2,20,000

Gross Working Capital can be calculated as,

Gross Working Capital = Cash + Debtors + Inventory

= 60,000 + 90,000 + 2,20,000

                                        = ₹3,70,000

Now, the Current Liabilities of the organisation are as follows:

Bills Payable = ₹50,000

Creditors = ₹20,000

Outstanding Expenses = ₹30,000

Net Working Capital can be calculated as,

Net Working Capital = Current Assets – Current Liabilities

= 3,70,000 – (50,000 + 20,000 + 30,000)

                                      = 3,70,000 – 1,00,000

                                      = ₹2,70,000

Working capital of an organisation is dependent upon the time period spent in converting raw material to finished good and selling those finished goods it in the market. It is called operating cycle of a buisiness.

What is Operating Cycle?

An Operating Cycle can be defined as the time duration that starts from the procurement of raw materials or goods and ends with the sales realisation. The nature and length of an operating cycle vary from one firm to another as it depends upon its size and nature. A firm needs working capital for this time period so that it can maintain sales activity. 

In a manufacturing company, the operating cycle is the length of time required to complete a series of events described as follows:

1. Conversion of cash into raw materials.
2. Conversion of raw materials into work-in-progress.
3. Conversion of work-in-progress into finished goods.
4. Conversion of finished goods into accounts receivable.
5. Conversion of accounts receivable into cash.

In a trading company, the operating cycle is the length of time taken for Procurement of Goods and Realisation of Sales Revenue.