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Importance of Working Capital

Definition of Working Capital

The term “Working Capital” means those liquid funds whether in form of cash, deposits in a bank, or either way which are kept by an enterprise to manage the day-to-day running expenses of the business, it can simply be said that the fund kept managing daily operations is known as Working Capital.

Formula

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To calculate the working capital or liquid funds of a business, below mentioned formula can be used:

Working Capital = Current Assets (Net of Depreciation) – Current Liabilities

Explanation

It cannot be said that the requirements of funds or working capital should be judged accurately as no one can judge the same accurately. A nearby calculation is to be prepared on the basis of future events and as per past results and expenses incurred. The requirements could be managed by choosing the alternative options as available for instance the inventory method could be changed to the Just-In-Time (JIT) method from the holding of some fixed level of inventories, change of duration of credit period given to trade receivable or duration of trade payables payments, etc. will also help in the management of funds.

Sometimes the enterprises may also take working capital loans from the financial institutions for the management of funds and pay for the expenses timely. Otherwise, it can be said that the proper management of working capital is much more important for start-ups or for small enterprises for which the loans from financial institutions could not be easily sanctioned.

Top 11 Importance Points of Working Capital

Below is the importance of working capital:

  1. Liquidity Management: By properly analyzing the expenses payable or to be incurred in the near future the financial team of an enterprise would easily plan for their funds accordingly.
  2. Out of Cash: Inappropriate prepared plans of day-to-day expenses may result in enterprise liquidity issues. They have to postpone or to arrange funds from some other sources which gives a bad impression of an enterprise at the party.
  3. Helps in Decision Making: By correctly analyzing the requirement of funds for day-to-day operations the finance team can appropriately manage the funds and can decide accordingly for available funds and for the availability of funds also.
  4. Addition in the Value of Business: As the management accordingly manages all the day-to-day required funds that help the authorized personnel to timely pay for all the outstanding creates a value addition or goodwill enhancement in the market.
  5. Helps in the Situation of Cash Crunches: By properly managing the liquid funds one can help the organization not to affect the situation of crises or cash crunches and pay for its day-to-day expenses on a timely basis.
  6. Perfect Investments Plans: Correctly managing the funds or working capital one can choose or plan for their investments accordingly and invest the funds to maximize the return as per their availability.
  7. Helps in Earning Short Term Profits: Sometimes it is seen that the enterprises keep a heavy amount of funds as working capital which is far over and above the required level of working capital. So by correctly preparing the required working capital those extra funds could be invested for a short span of time and could create value in the profits of the enterprise.
  8. Strengthening the Work Culture of Entity: Timely payment of all the day-to-day expenses mainly focused on the salary of the employees creates a good environment and a sort of motivation amongst employees to work harder and strengthen the good working environment.
  9. Improves Creditworthiness of Entity: When the enterprise has adequately planned their working capital requirements, they will surely pay the payments to vendors and other creditors timely which improves their creditworthiness and could help them to get the funds as and when required easily.
  10. Act as Guarantor to Other Enterprises: When an enterprise has created such a good image in the market then the business could also help some other enterprises and in favor gets business profits and contracts done easily.
  11. Good Reputation of Entity: Easy way to create a good reputation in the market which in turn helps the organization or entity easily get contracts because of a good image and fulfilling their commitments on time. Nowadays, everyone wants to deal and do business with such parties whose market reputation and creditworthiness are good due to an increase in fraud and manipulations.

Conclusion

To conclude the working capital in any business plays a crucial and vital role in achieving the organizational goal and enhancing the profitability of the business. The calculation of working capital may be done on a monthly, quarterly, or on yearly basis. Generally, it is preferred to calculate the working capital requirement and availability every quarter so that further decisions could be taken accordingly as per the availability and requirements and the spare funds should be invested in such a manner so that the returns from the same could be maximized.

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This is a guide to the Importance of Working Capital. Here we discuss the formula to calculate, and top 11 Importance of Working Capital. You can also go through our other related articles to learn more –

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