In continuation of our series on “Accounting Basic for Startups”, this article will throw light on the calculation and interpretation of key financial ratios for evaluating the performance of a concern.
Working Capital Management is a process to check whether your current assets or easy convertible into liquid cash are enough to cover your current liabilities or expenses. Comfortable Working capital suggests financial viability and sustainability, as it indicates that the Startup has sufficient cash in order to meet its short-term debt obligations and operation expenses. Before discussing about Working Capital Management, let’s get versed with some basic terms and concept of Working Capital.
Working Capital measures both company’s efficiency and its short term financial health. The working capital ratio is calculated as below is calculated as below - Working Capital = Current Assets + Current Liabilities
Ingredients of Working Capital
Current Assets - A balance sheet item which represents liquid cash and cash equivalents, accounts receivables, marketable securities, inventory, prepaid expenses and all other assets that could be converted to cash easily.
Current liabilities – A company’s debts or obligations that are due in near future, and includes short term debts, accounts payable, accrued liabilities and other debts.
Value and Time Concept in Working Capital
VALUE: From the value point of view, Working Capital can be segregated into Gross Working Capital or Net Working Capital.
- Gross Working Capital - It refers to the firm’s investment in current assets
- Net Working Capital - It refers to the difference between current assets and current liabilities
A positive working capital means that the company is able to pay off its short term liabilities, whereas a negative working capital suggests that the company currently is unable to meet its short term liabilities.
TIME: From the point of view of time, it is referred as permanent or temporary.
- Permanent - Permanent working capital refers to the minimum level of investment in the current assets by the business at all times to carry out minimum level of activities.
- Temporary - Temporary working capital also known as variable working capital refers to that part of total working capital, which is required by a business over and above permanent working capital.
Importance – Effective Working Capital Management
Founder of a Startup is accountable to determine and ensure the requirements of working capital carefully in such a way that the amount of working capital available with him is neither too large nor too small for its requirement. As large amount of it would mean that the Startup has ideal funds. Since the funds have a cost, they have to pay interest on such funds. On the other hand if there is inadequate working capital, then the business might run into risk of insolvency, and continued paucity of adequate working capital can seriously challenge the financial viability and sustainability of the business.
Optimum Working Capital
There is no standard rule for an Optimum Working Capital. The working capital requirements vary from industry to industry. Traditionally, Current Ratio (Current Assets: Current Liabilities) of 1.5 to 2 is considered to be comfortable liquidity position. However, it should be remembered that optimum working capital can be determine only with the reference to a particular circumstances. Thus, for an example: If a firm has sundry debtors, as good as liquid cash then, in that scenario even a current ratio above 1 would be comfortable for the business.
DETERMINANTS OF WORKING CAPITAL
Cash - Identification of cash balance for meeting day to day business expenses.
Inventory - identifies the level of inventory needed for uninterrupted production, also which reduces the investment in raw materials.
Debtors – It identifies the appropriate credit policy, i.e., credit terms which will attract customers.
Small or Large Business - It is the determinant of working capital that it is affected with the nature of business.
Small or Large demand – The urgency of the demand of the product in the market also determines the level of working capital required for a business.
Technology and manufacturing policy – for instance in some businesses the demand for goods is seasonal, in that case a business may follow a policy for steady production through out over the whole year or instead may choose policy of production only during the demand season.
Price Level changes –businesses using raw material having price volatility would require higher level of working capital vis-à-vis a price stable input raw material.
Effect of external business environmental factors - There are external business environmental factors which affect the need of working capital like fiscal policy, monetary policy and bank policies and facilities.
Business cycle – every business considering the cycle of business it is in, would have different level of working capital requirements.
The actual sustainability of business is established when it is able to pay off its day to day expenses from day to day revenue. Normally, businesses make the mistake of paying of day to day expense with infrastructure resources in the absence of proper working capital requirement analysis.
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