Working capital – what is it?
Working capital is nothing more than funds available to a company to cover its daily needs. However, to use the term efficiently, we also need to learn about the concept of current assets.
Current assets consist of the company’s accumulated inventory, cash, accounts receivable and marketable securities. These assets – to be counted as current assets – must be intended for use within 12 months.
Important!
Working capital is otherwise known as gross working capital.
To calculate net working capital, it is necessary to subtract the following components from current assets:
- Invoices issued by contractors;
- salaries for employees;
- Social Security contributions;
- taxes;
- loan installments;
- lease installments;
- All other obligations.
The above formula (Working Capital = Current Assets – Current Liabilities) is used in the short-term (asset-based) approach to calculate working capital. The amount thus received should be sufficient to cover all the ordinary needs of the company for an unspecified period of time. The higher the value of working capital accumulated by a company, the less threatened is its liquidity.
Important!
Net working capital may also appear under the name working capital.
There is also a long-term (capital) approach to calculating working capital – in this arrangement, the value of fixed assets is subtracted from fixed capital.
How does working capital work?
Working capital is the company’s internal hedge against potential problems that an entrepreneur may encounter. Delays by customers in paying receivables, problems with material deliveries, production or sales – all of these can put a company in a situation where it needs to pay salaries, pay taxes or settle short-term obligations without access to funds from regular receipts (or with fewer funds than usual). Net working capital is supposed to protect the company from having to take out loans or borrow money to pay off current liabilities.
Working capital management strategies
In theory, the more working capital, the better for the company. Yes, the company’s liquidity increases with the amount of working capital, but with a large amount of capital, the company also has to reckon with increasing costs of maintaining it, and thus lower profits. In order to achieve optimal results, it is necessary to adopt the right strategy for the company to take care of all components of working capital while increasing profits.
Conservative strategy
This approach results in a high level of liquidity, but relatively low profits. For entrepreneurs who value security, this will be a suitable solution, as it involves very low risk. What does it consist of?
In a conservative strategy, the company finances current assets using fixed capital – it accumulates and maintains a surplus in the form of cash and short-term securities. In addition, the company seeks to minimize short-term liabilities. However, these actions have a dark side: they translate into increased service costs and, consequently, lower profitability for the company. This is the price for a much lower risk of insolvency.
Aggressive strategy
Aggressive working capital management involves financing assets with little or no fixed capital. In the latter option, all current assets are financed with liabilities and short-term loans. This approach assumes either having minimal working capital or no working capital at all.
The aggressive strategy is characterized by a very high level of liquidity risk, but at the same time yields the highest returns. Similarly, the cost of servicing capital is low, so the profitability of the company increases.
Moderate strategy
As you can easily guess, the moderate strategy combines features of the two previously discussed strategies. It is about maintaining a relatively high profitability of the company, while making efforts to reduce the risk of insolvency. It is readily used by companies that have to face seasonality on a regular basis. In such an arrangement, current assets are most often financed with fixed capital in the off-season, while liabilities and short-term loans are used during the season.
This is a relatively safe solution that can only be threatened by a really serious cause. An example is the COVID-19 pandemic, which has caused a lot of problems in many industries, such as tourism.
Working capital requirements
Regardless of the tactics adopted, an enterprise may, as a result of various circumstances or business decisions made, need access to accumulated working capital. Such requirements can be easily calculated by subtracting the net cash balance from the value of working capital.
Important!
A number of factors influence the amount of a company’s working capital requirements. One is for suppliers to shorten the company’s repayment terms. Another potential reason is an increase in sales (reverse charge). A third reason may be prolonged payments from customers.
How to fill the financial hole?
Accumulated working capital is not always sufficient for all needs – this is encouraged, for example, by an aggressive capital management strategy. In a situation where there is a financial hole in the company and funds are needed to settle invoice payments, pay salaries or pay other obligations, it is worth considering taking advantage of online factoring– it’s a safe and secure solution for recovering frozen funds to be credited to the company’s account from customers in the future. The unquestionable advantages of factoring are the short waiting time for the decision and transfer of funds, the possibility to arrange all the formalities online, and the fact that the use of factoring does not increase the company’s debt and does not negatively affect its liquidity. An additional advantage is a wide range of additional services. Among the most popular is the option to transfer the risk of counterparty insolvency to the company providing the factoring service, as well as factoring receivables insurance or the option to finance essential business purchases with factoring.
Find out what online factoring at PragmaGO is all about and get your liquidity back today!
