We all have heard about the term called working capital. What is the meaning working capital? Why working capital is so important in business? Why working capital cycle should be calculated in any business transaction.

Working Capital is a tool used to indicate short-term financial position of any business. Working capital means the gap between current assets and current liabilities. Working capital gap can be positive or negative. When current assets are more than current liabilities, the gap is called positive working capital which shows the healthy working capital and healthy current ratio. On the other side, if the gap is negative which means there is a negative working capital gap, the business has more creditors than stock and debtors which create liquidity problems. Thus, working capital or working capital gap measures the overall efficiency of the business.

If we divide current assets with current liabilities, the ratio is called current ratio. If the current ratio is more than 1 that means working capital gap is positive and company would be able to pay to its suppliers by selling stock and realizing money from debtors.

Working Capital analysis states what should be the levels of inventory, debtors and other current assets. If for example, a business has turnover of Rs. 120.0 million per annum and total outstanding current assets are Rs. 30.0 million and current liabilities are Rs. 20.0 million then there is a working capital gap of Rs. 10.0 million. In this case, gross working capital cycle is about 25% of turnover which is equivalent to three months period and net working capital cycle is 8.33% of turnover which is one month.

Further dissecting the component of working capital i.e. debtors, stocks and creditors, we come to know the individual ratios of debtor holding period, stock holding period and creditors period.

Longer the working capital cycle of any business, higher the working capital requirement. Some of the businesses like retail business need to maintain higher amount of inventory and therefore the requirement of working capital is also higher. Similarly, if a company allow long credit period to debtors or deal with government parties, generally has longer working capital cycle.

Sources of working capital can be either equity or debt. Working capital which comes from equity or generating profits is a long term source. If you are borrowing working capital through bank or NBFC, it can be long term or short term or both. There is another source of working capital which is trade payables.  If we can fulfill our working capital requirement only through trade payable then banks do not provide working capital.

  • Working capital by promoters/shareholders – In this form, working capital is infused by owners of the company through equity or quasi equity. Generally this form of working capital is non interest bearing and long term in nature. Companies which are cash rich or very small, generally use working capital through own resources.
  • Working capital by trade payable – when we purchase any material on credit or avail any service on credit, we pay to the supplier after certain number of weeks or months, by the time we sell the final product and realize the money from the customer and pay back to trade payable. In this case, working capital can be met through trade payable. Generally, this is not possible and therefore, companies borrow working capital funds through banks/NBFCs.
  • Working capital by Bank/NBFCs – Banks provides working capital after due assessment of requirement, credit profile of the borrower, security available and through sanction letter. Banks provide working capital in the form of cash credit, WCDL, packing credit(for export units), overdraft facility and in the form of letter of credit.

Working capital is the gap between current assets and current liabilities. In a balance sheet statement, working capital can be seen under secured or unsecured bank borrowing or under current liabilities. This is called on-balance sheet working capital. There is another type of working capital which is called as off-balance sheet item working capital i.e. receivable discounting, sales bill discounting, purchase bill discounting which gets net off from respective transactions and comes in the notes to accounts of the balance sheet. These all are the types of fund based working capital.

Broadly, working capital has two types: fund based working capital and non fund based working capital.

In the fund based working capital, the company actually avail working capital through banks in cash. This type of working capital includes cash credit, overdraft, packing credit, receivable discounting, etc. Banks assess working capital amount by MPBF method (maximum permissible bank finance) or turnover method (for working capital upto Rs. 5.0 crore) or cash flow gap method(for seasonal industry like sugar).

In non fund based working capital, the company can avail working capital in the form of letter of credit(for purchase of goods), bank guarantees(to bid, perform or mobilize orders), SBLCs(to avail fund based credit from other banks) or derivative facilities which includes plain forwards, options and other hedging contracts.

Both fund based and non fund based working capital funds can be availed through banks, however, banks check the credit and financial profile, requirement, perform other due diligence, see the track record of the borrower and understand the cycle of the business before lending any working capital.

We as working capital consultants, help our client to get the working capital through various banks and NBFCs. We thoroughly understand the working capital proposal and then coordinate and provide sanction through banks.


Tags: Financial Adviser in Delhi, Working Capital Management, Bank DMA