It might sound obvious, but a business cannot operate without money. Ensuring you have enough to pay for all your operational expenses is vital for a company to stay in business. Many businesses fail because of a lack of funds for daily operations, not because of a lack of profits.
Working capital is one of the most critical parts of a business, and it requires a balance of just the right amount of funds. Check out this article to learn about the different types of working capital and some suggestions on how to manage it.
What is working capital?
Working capital is the difference between a company’s current assets over current liabilities. It includes the money coming in and money going out. Overall, it calculates the liquid assets a company has to pay its bills and continue operating. The working capital formula looks like this:
Working Capital = Current Assets – Current Liabilities
For example, Company A has current assets (cash, accounts receivables, inventories) that total £100,000 and current liabilities (accounts payable, short-term borrowings, accrued liabilities) that equal £50,000. Therefore, Company A’s working capital formula would be the following:
£100,000 - £50,000 = £50,000
What does this mean for Company A? They have £50,000 to help grow the company.
Types of working capital
When it comes to working capital, there are 8 different types:
Gross working capital: This type of capital is the amount a company has invested in assets that can quickly convert to cash. Assets high in liquidity, such as stocks, could fall under this category.
Net working capital: The difference between current assets and current liabilities, net working capital can be positive or negative and shows a company’s liquidity. When you refer to working capital, this refers to a company’s net working capital and indicates if it can meet its short-term financial obligations.
Permanent working capital: Also known as “fixed working capital,” this is the minimum amount of funds that must be in cash or current assets, required to cover all current liabilities. The amount of fixed capital a business requires depends on the size and growth of that business. The bigger the business, the more fixed or permanent working capital will be needed.
Temporary working capital: Also known as “variable, fluctuating, or cyclical working capital.” It is the difference between net working capital and permanent working capital.
Regular working capital: This is the least amount of capital required to meet current working expenses under normal conditions. Some examples of this capital include salary and wage payments, materials and supplies, and overhead costs.
Reserve Margin working capital: Think of this type of working capital like a “safety cushion”. This is the amount of “rainy day” funds set aside for unforeseen circumstances such as natural disasters, strikes, layoffs, or inflation.
Seasonal working capital: Related to the seasonal demand of products, this kind of working capital includes the additional amount a business needs to operate during the peak season. It can also be considered a variable type of working capital.
Special working capital: Included under temporary working capital, this is for unforeseen or exceptional circumstances such as accidents, marketing or advertising campaigns, or new product development endeavours. This is also another type of variable working capital.
Working capital cycle
The working capital cycle, also known as the “cash conversion cycle,” is the amount of time it takes a business to turn net working capital into actual cash. The longer the cycle, the longer a company is tying up capital without a return on investment.
The goal is to collect receivables as quickly as possible or by stretching the accounts payable. Use this formula to calculate the working capital cycle:
Working Capital Cycle = Inventory Days + Receivable Days – Payable Days
Working capital management
Most businesses aim for a negative working capital cycle because that would mean they are moving inventory at a quicker rate, receiving customer payments within a shorter period, and stretching their own payment terms. However, sometimes working capital management is needed to help a company operate more efficiently.
The goal is to ensure a business can continue to operate with enough cash flow and pay off current and future debts, while also still investing company assets in an optimal way for future growth. The decisions used within working capital management help to manage a company’s relationship with short-term financing.
Additional components include coordinating and managing inventory and payables, short-term investments, and granting credit to and collecting from customers. Overall, it requires reliable cash forecasts and accurate financial data to manage the working capital.
Working capital loan
Growing a business requires funds to operate, and some might consider a working capital loan. This type of loan can be helpful if a company has exhausted all other funding options and needs funding for operational expenses like rent, payroll, or utilities. For seasonal or cyclical types of businesses, a working capital loan is beneficial because it is a flexible loan option that can quickly help to cover immediate expenses.
A working capital loan can also offer some flexibility to keep the business running during periods of low income. Plus, some might see this type of funding option as an advantage as it is not investor funding, which means you can take complete ownership of the funds and decide how they are used.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.