What Does Working Capital Requirement Mean?

Working capital is the amount of money that a company has to carry on with its daily operations. To determine working capital requirement, let's first learn how to calculate working capital.

A company has two kinds of assets namely fixed assets, such as property and machinery, and current assets. The current assets of a company are those which will be used up within a single fiscal year. They include cash in hand, cash at bank, accounts receivable, pre-paid expenses, inventory, and short term investments.

Current liabilities are those which have to be settled in cash within the current fiscal year. They include all the accounts payable pertaining to goods and services, including short term loans payable within one year. Working capital is the difference between the current assets and the current liability.

The mathematical formula for calculating Working Capital is:

Working Capital = Current Assets - Current Liabilities

The net working capital requirement varies from company to company. And within the company itself, it may vary from month to month. It depends on two factors, namely, how much earnings a company has and what is the frequency of receiving those earnings. Secondly, what are the expenses that a company has and how frequently these payments have to be settled.

For determining how to calculate working capital requirement for a new investment, the business managers have to make forecasts of the earnings i.e. accounts receivable, inventory, as well as the expenses i.e., accounts payable.

After the projections have been made, you have to compare the actual earning and expenses with the projections. Next, add the increase in accounts receivable and the increase in inventory, and subtract the accounts payable from this amount. The figure you then get will reflect the probable change in working capital, which can be used for the new investment.

This change is also determined through the inflow and outflow of funds. So these two things should also be taken into consideration while calculating the working capital requirement.

The mathematical formula is:

Working Capital Required = (Increase in accounts receivable + Increase in inventory + Cash inflows i.e., cash in bank, bank loan, other current assets) - (Increase in accounts payable + Cash outflows i.e., prepaid expenses, payment to suppliers, other current liabilities)

Working capital management is very important to ensure that the company has enough funds to carry on with its daily operations, smoothly. A business should not have a very long cash conversion cycle, which measures the time period for which a firm will be deprived of funds, if it increases its investments as a part of its business growth strategies.

For this, the company has to take certain measures such as reduce the credit period of the customers, negotiate with the suppliers, and increase its own credit period with them, maintaining the right level of inventory, which reduces the raw material costs and proper cash management which ensues that cash holding costs are reduced.

If these measures are followed, the requirement automatically comes down. There are a few other things to consider. If the current liabilities of a company are more than the current assets, it represents a working capital deficiency, and may sometimes lead to business debt.

A deficit working capital has a negative impact on the company's image, as it depicts problems in liquidity of the company, and is unable to pay its short-term costs. In such a case, the investors may back out on any kind of investments in the company. Thus, financial planning, including working capital planning, is essential to run a business efficiently.