Step-by-Step Instructions to Calculate the Working Capital Requirement for Your Business

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The effectiveness of planning and management depends on an accurate estimation of the working capital requirement. A precise assessment of the amount of working capital required is essential for excellent and effective working capital management. This is true regardless of the planning exercise that was performed or the control mechanism that was chosen. This article will look into the steps with regard to calculation of working capital requirement for a company.

What Is Working Capital Requirement?

Working capital, which may also be referred to as net working capital (NWC), refers to a company’s ability to satisfy its current liabilities with its current assets. It is a piece of statistics used in finance to identify whether or not a company has adequate liquid assets to fulfil its obligations that are likely to be due fairly soon. When a company has current assets that are more than its requirements, the extra cash that the company has may be used in the organisation’s day-to-day business.

It is necessary to identify the appropriate category for each of the many assets and liabilities shown on a company’s balance sheet to gain insight into the overall health of a firm and its ability to repay its short-term obligations. This is accomplished by analysing the company’s balance sheet. This may be a challenging assignment.

Working Capital Components

Before we learn how to calculate working capital requirement for a firm, consider the following factors that influence working capital.

Current assets

The term, “current assets”, refers to any liquid asset that may be turned into cash during a year. Among them are:

  • Money in the bank and consumer cheques that have not yet been deposited
  • Prepaid insurance premiums and other expenditures
  • An inventory of completed items, raw materials and work-in-progress products
  • Accounts receivable without regard for allowances for accounts that are unlikely to be paid
  • Payments paid in advance for future purchases
  • The company’s short-term investments that it hopes to sell in a year
  • Money owed to suppliers or customers that will be paid back during a year, including notes receivable
  • Insurance claims, employee cash advances, and income tax returns are examples of receivables.
  • Investments in money market funds and other securities

Current liabilities

Your current liabilities include any debts that are due in the year, such as:

  • Long-term obligations due during a year
  • Amounts owed to creditors
  • Taxes owed
  • Wages for employees

Business loan interest rate

  • Loan principle that must be paid back in a year
  • Expenses incurred
  • Payments in advance for products and services that have not yet been provided

Types of Working Capital Formulas

You may choose one of the numerous models depending on how precise you or your analyst wants your working capital calculation to be.

The most comprehensive calculation takes into consideration all accounts:

  • Some firms choose a more specific calculation for simplicity:

Working Capital = Current Assets (minus cash) – Current Liabilities (minus debt)

  • Some people even employ a formula with just three accounts:

Working Capital = Accounts Receivable + Inventory – Accounts Payable

Formula to Calculate the Working Capital

The working capital formula calculates the amount of short-term liquid assets available after short-term obligations are paid off. It is an assessment of the short-term liquidity of a business and is helpful for the management of cash flow, financial analysis and financial modelling.

Step 1: Determine all current assets (CA).

Step 2: Determine all current liabilities (CL).

Step 3: Deduct the CA from the CL (CA – CL).

How to calculate working capital

Below is an example to make you understand how to calculate working capital:

Current Assets Amount (Rs.) Current Liabilities Amount (Rs.)
Debtors  1.5 lakh Creditors 50,000
Unsold inventory 25,000 Outstanding expenses 10,000
Raw materials 15,000
Obsolete stock 5,000
Cash in hand 25,000
Prepaid expenses 1,500
Total 221,500 Total 60,000

Working capital = Current assets – Current liabilities

Working capital = Rs. 221, 500 – Rs. 60,000 = Rs. 161,500 

So, your company’s working capital is Rs. 161,500.

Importance of Using the Working Capital Formula

The method of calculating working capital provides you with insight into your cash flow position, ensuring that your company has sufficient funds available to support the ongoing success of its operations. This includes fulfilling the financial commitments you have on a day-to-day basis. However, it is also essential for fostering expansion and making your company more resistant to fluctuations in revenue and profits. If you have access to operating cash, you are prepared to deal with any unanticipated expenses.

At the same time, having enough operating cash allows you to rapidly react to new possibilities and assists your company in withstanding any challenges that may arise. At some point or another, the majority of enterprises will experience periods of downtime.

Positive or Negative Working Capital

When a business has positive working capital, it has adequate cash left to pay off short-term loans and support the development of the company’s operations using its resources. This is a promising sign about the organisation’s financial success in the immediate run. Working capital shortages might cause a company to seek outside help from investment bankers or take out a business loan from a financial institution.

When a company’s working capital balance is in the red, its assets are not being used to their maximum potential, and the company faces the danger of a liquidity crisis. Regardless of the amount of money that has been put into purchasing fixed assets, if a company has commitments that are soon to be due, the company will run into problems on both financial and operational fronts. This might lead to the company taking out additional working capital loans, making late payments to its creditors and suppliers, and eventually having a worse corporate credit rating.

How to Deal out Your Working Capital Requirement

A significant number of companies have to pay their bills before they can collect any profits from their sales. The period is known as the working capital cycle or the operational cycle. It refers to when your company pays money out (for example, to suppliers) and when it gets money back (for example, from sales). The amount of money necessary to pay the costs associated with this delay is your company’s working capital requirement.

The working capital cycle method of calculation is, Inventory Days + Receivable Days – Payable Days = Working Capital Cycle in Days.

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