WHAT IS WORKING CAPITAL? WHY IT IS REQUIRED AND WHAT ARE THE COMPONENTS OF WORKING CAPITAL?

 In my last article we understand about ROCE and components of capital employed. If you remembered, Working capital is one of the components of Capital Employed in the business.

In this article, we will understand the meaning of working capital and why it is required in the business? What all things to be included in working capital?

We all will make out all these questions by the end of this article. 

What is Working capital?

In very simple words, Working Capital is the fund available to run our business day-to-day activities smoothly. 

In general, in a manufacturing company we need to procure raw material, and after processing we produce finished product and then this product reaches customers. Right? 

But the point to be note here is, 

What if the company is not able to procure raw material timely?

What if company is not able to pay it's employee? 

What if company is unable to receive timely payments from it's debtor or any other adverse situation where company is unable to bear expense due to cash or bank balance unavailability? 

Here, Working capital management comes into picture. But before that again let me tell you, working capital is the component of capital employed in the business to provide liquidity to our day-to-day operations and is also represented by Current Assets. Till now we are talking about gross working capital. For example - paying our short term loans, Paying salaries to employee, Procurement of raw material etc.

                        GROSS WORKING CAPITAL = CURRENT ASSETS

THEN WHAT IS NET WORKING CAPITAL??🤔🤔

Net working capital is excess of current assets over current liabilities. It consider Current assets and Current Liabilities both.

NET WORKING CAPITAL = CURRENT ASSETS - CURRENT LIABILITIES

Net Working capital is positive when current assets is more than current liabilities and negative when current assets is less than current liabilities.

But why we are learning gross working Capital and net working capital separately?

Here following points can be noted -

• By Gross Working Capital we are ascertain the total funds available to dispose off the short term loans and payables. But Net Working capital is helping us to understand the company's short term liquidity position.
• Gross Working Capital tells us quantitative info but Net working Capital tells us something qualitative about the company's short term financial position.   

What are the components of Working Capital?

Current Assets

Current Assets are those assets which are going to give economic benefits within the operating cycle of the company. Here, operating cycle basically refers to the time period to procure raw material to generation of cash through sales from finished product.

• Cash and Cash Equivalents : This include all the money company have in hand, like cash in hand, Cash in bank. This will include some investments with very low risk and very short period of investments, generally 3 months.

• Inventory : All the goods being unsold is covered under Inventory. And this includes semi-finished goods, raw material and finished goods that have not being sold.

• Prepaid Expenses : All the expenses paid in advance. Though it may be difficult to liquidate in case of need but still have some future benefits and hence included.
• Accounts Receivables: All the claims for cash to sale our products on credit. This should be considered net of any doubtful payment.
• Others : Any other current assets like short term deferred tax assets that reduces future liability.

Current Liabilities

Current Liability simply the short term debts company needs to pay within the operating cycle of the company. The objective of working capital is to ascertain that whether company is able to pay all these debts with the short term assets it already had on hands.

• Wages Payable : All unpaid salaries and wages for the staff. These liabilities are very short term in nature.
• Accounts Payable: All unpaid invoices to creditors for supplies, raw materials, utilities, or any other operating expenses owed by the company.
• Dividend Payable : All authorized payments to shareholders that have authorized. 
• Unearned Revenue : Amount  received in advance for which goods/ services not yet provided to customer. This will create an obligation on the company to return the amount if company is unable to provide goods/Services to such customers.
•  Accrued tax Payables : This will include amount of statutory dues to government bodies.

EXAMPLE OF WORKING CAPITAL

Let us calculate working capital as on 31 March 2022 of one of the best companies in India Reliance Industry Limited.

At the end of year 2022, Reliance Industries (RIL) reported Rs.2,22,398 Crore of Current assets. This includes Inventories, Investments, Trade Receivables, Cash and Cash equivalents, Loans given, other financial assets and other current assets.

The company also reported Rs.2,00,982 Crore of Current Liabilities. This includes Borrowings, Lease Liabilities, Trade Payables, Other Financial Liabilities, Provisions and other current liabilities.

Therefore, at the end of Year 2022 the Gross working capital of reliance industry is Rs.2,22,398 Cr. and Net Working Capital of Reliance Industries is Rs.21,416 Cr.

Hence, we can conclude that company is able to pay all it's short term debt and still remain Rs.21,416 Cr. with it.

We do have left with one more question that is , How a company can estimate it's working capital requirements?

I'll answer this question in a very simple way in next article.

Thankyou for your patience!

I'll back with more interesting terms using in Financial analysis.