Working capital loan is a short-term credit provided by banks or alternative lenders to fund day-to-day business operations. The primary objective of working capital loans is to provide funds for businesses to address short-term capital expenses like:
- Wages or debt service payments
Note: Working capital can also be utilized to endorse activities like research and development or sales and marketing.
Understanding How Working Capital is Used
Working capital exhibits the number of funds a business has at its disposal to meet momentous expenses. When a company has more working capital, it augments the business’s financial status.
Some businesses use amplified amounts of working capital to address seasonal expenses. Concurrently, other businesses utilize working capital to bridge the gaps in revenue when sales are low at a given time in the year.
Drivers of Working Capital
Every enterprise has short-term assets and liabilities. The short-term assets of a company are called Current Assets. The short-term liabilities, on the other hand, are called Current Liabilities.
In short, the difference between the current assets value and current liabilities value for a period is the working capital.
Now let’s get a comprehensive understanding about current assets and liabilities.
1. Current Assets
An asset that can be accessed and used within 12 months is called a current asset.
These are a company’s short-term assets that can be converted into cash. Current assets are mostly used to pay off debts and include:
- Cash and Cash Equivalents – comprising cash, like funds in a savings account. Cash equivalents are liquidated assets like treasury bills and money-market funds.
- Marketable Securities- like mutual fund shares, stocks, and some bonds
- Inventory- the commodity that can be easily liquidated or sold within a year.
- Accounts Receivable- the outstanding money owed to the company by the debtors/ customers in exchange for the products or services.
2. Current Liabilities
It is an interim expenditure owed by a company. It must be paid within the 12-month period.
Current liabilities mostly include:
- Short-term Debt- payments that comprise commercial or bank loans generated to fund business operations.
- Suppliers and Vendors – payable for raw materials, inventory, and services like technology support.
- Accounts Payable– the short-term payable bills
- Interest Payments– payable to banks and bondholders. Such payments can include present interest payments for long-term debt and short-term debt.
- Taxes owed– like payroll and income taxes, payable in the next year.
Interpreting and Adjusting Working Capital
The distinction between current assets and current liabilities is termed working capital. Hence, it can be a positive number or a negative number too.
However, positive working capital is always recommended because it implies that a company has ample funds to meet sudden operating expenses. But, with time, the net working capital amount can change because of unforeseen expenses. Consequently, such expenses can also compel the company to experience a negative working capital tenure.
Businesses track their account receivables to analyze when they are expected to get payment from their respective customers. Not to mention companies also track their accounts payable to analyze when suppliers need to be paid.
In case the accounts payables are due earlier than the amount outstanding from accounts receivables, it is quite likely that the company will undergo a shortage in working capital.
Sources of Working Capital
Here are the origins of working capital:
- Funds from Business Operations: Funds from business operations (FFO) are determined by adding amortisation, depreciation, and the loss on assets sale and subtracting any interest income and gains on the sale of assets.FFO does not include one-time cash inflows like income from an asset sale. Instead, it comprises revenue from business activities.
- Sales of Non-Current Assets: A company can acquire working capital by exchanging non-current assets like long-term investments, plants, or equipment with current assets. If current assets are received, the sale is considered a source of revenue, even if the non-current assets are sold at a loss or a gain.
- Long-Term Borrowing: Long-term borrowing, like the issue of bonds or debentures, leads to an upsurge in current assets. As a result, it leads to a rise in working capital. However, short-term borrowing does not boost working capital. When a business signs a short-term note payable or acquires a short-term credit, the working capital remains the same. It is because the rise in current assets counteracts the increase in current liabilities of the exact figure.
- Issue of Additional Equity Capital: The problem of extra equity shares leads to an influx of current assets. Consequently, it increases the working capital. Likewise, more investments of current assets by business owners display a source of revenue in partnership and single proprietorship.
Uses of Working Capital
Here are the applications of working capital:
- Declaration of Cash dividend: The acknowledgement of cash dividends leads to a liability called dividend payable, which is a use of capital.
- Real payment of the dividend: Real payment of the dividend decreases current liabilities and current assets by the same amount. Hence, it has no impact on the working capital amount. The issue of shares rather than dividends does not include asset distribution; therefore, it is not a use of capital.
- Purchase of Non-Current Assets: Buying non-current assets like equipment or plant increase current liabilities or decrease current assets. In both scenarios, working capital decreases.
- Repayment of Long-Term Debt: When current assets are used for repaying long-term debts, the working capital gets reduced. However, reimbursement of short-term debts is not considered a use of capital because current assets and current liabilities get reduced by the same amount.
6 Ways to Increase Working Capital
A company or a business may strive to increase the working capital to meet uncertain expenses or adjust to the momentary drop in sales. The methods to increase working capital include decreasing current liabilities or adding current assets.
The options are:
- Clearing long-term and short-term debts- It decreases current liabilities since the debts are cleared in a year.
- Evaluating and decreasing costs, minimising the current liabilities.
- Availing a long-term debt- It increases current assets by increasing the company’s available cash; however, it does not increase the overall liabilities.
- Automate payment tracking and accounts receivable- It can boost the cash flow, reducing the need to withdraw working capital for everyday operating expenses.
- Boosting current assets value by selling illiquid assets.
- Evaluating and improving inventory management to decrease the possibility of overstocking.
Does Working Capital Change?
Working capital differs between companies. Several factors can influence the working capital amount, such as seasonal sales fluctuations or huge outgoing payments. Hence, the working capital changes.