Types of Working Capital Used in a Business

Working capital refers to funds that are available for meeting short term and current obligations. The requirement for the amount of working capital is calculated based on the future needs.

In this article, we will be discussing different types of working capital that are used in any business. 

Table of Contents

• What is working capital?
• Working capital formula
• Requirement of capital
• Types of working capital

What is working capital?

Working capital is an important component of the business. No organization can work effectively without this capital to meet day-to-day business needs. Without the availability of sufficient working capital, the organization remains short of resources that are essential to run a business. However, excessive working capital is also not healthy since it increases the burden of cost for the business. 

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Let us learn more about working capital through these videos:

How to Calculate Working Capital?

It is the excess of current assets over current liabilities. This aggregate capital is used for fulfilling short-term obligations of the business to manage the efficiency of business operations. Firms can repay their short-term dues and day-to-day operating expenses. It measures the operational efficiency, liquidy position and short-term financial health of the organization.

Working Capital = Current Assets – Current Liabilities

Working Capital Calculation

A small cafe called "Cafe Cozy" wants to assess its working capital at the end of its fiscal year. Here's the information available:

Current Assets:

• Cash: $12,000
• Inventory (coffee, pastries, etc.): $5,000
• Accounts Receivable (money owed by customers): $3,000
• Prepaid Expenses (rent, insurance): $2,000

Current Liabilities:

• Accounts Payable (money owed to suppliers): $8,000
• Salaries Payable (wages owed to employees): $1,000
• Accrued Expenses (utilities, taxes): $500

Working Capital Calculation

Now, we can calculate Cafe Cozy's working capital using the formula:

Working Capital = Current Assets – Current Liabilities

Step 1: Sum all current assets.

Total Current Assets = $12,000 (Cash) + $5,000 (Inventory) + $3,000 (Accounts Receivable) + $2,000 (Prepaid Expenses)

Total Current Assets = $22,000

Step 2: Sum all current liabilities.

Total Current Liabilities = $8,000 (Accounts Payable) + $1,000 (Salaries Payable) + $500 (Accrued Expenses)

Total Current Liabilities = $9,500

Step 3: Subtract current liabilities from total current assets.

Working Capital = $22,000 (Total Current Assets) - $9,500 (Total Current Liabilities)

Working Capital = $12,500

Interpretation of Results

Cafe Cozy has a working capital of $12,500. This indicates that the cafe has sufficient current assets to cover its current liabilities. This surplus ensures Cafe Cozy can meet its short-term obligations like paying suppliers and employees without dipping into long-term assets or incurring additional debt. A positive working capital is generally considered a sign of good financial health for a business.

This information can be helpful for Cafe Cozy's owners to make informed financial decisions, such as managing inventory levels, negotiating payment terms with suppliers, or planning for future investments.

Requirement of the Capital

The following are the requirements of working capital:

1. The business cycle has an impact on the working capital requirement of a business. While the business is expanding, the requirement of working capital also increases. The increased business activity requires additional funds to meet the time lag between sales and collection. For inventory requirements, funds are also required to produce goods for increased sales. 
2. The production cycle also impacts the working capital requirements for a business. With a longer production cycle, the requirement for working capital is needed to fund its operational activities. 
3. With increased operational efficiency, a lesser amount of funds in working capital is required. If there is lesser operational efficiency, businesses require more funds that should be invested in the working capital. 

Types of Working Capital

The following are different types of working capital required in a business:

1. Permanent Working Capital 

It is the minimum amount of working capital that is required to cover all current liabilities in a business to continue its operations. As the liabilities in your business increase, the requirement for permanent working capital increases in your business. 

This capital remains permanently tied up to your current assets for undertaking business activities. In simple terms, it is the least amount of current assets that are required for effortlessly conducting the business. Due to this reason, it is also known as fixed working capital. Permanent working capital is of two types: regular working capital and reserve margin working capital. 

• Regular Working Capital: It is the minimum amount of capital that is required by the business for carrying out day-to-day business operations. Businesses must maintain regular working capital to maintain appropriate regular working capital for stable operations. 
• Reserve working capital: It is a type of fund that the business needs to maintain above the working capital needed. These funds are used by the business as a contingency for any unexpected situation. These are short-term financial funds that business needs. 

2. Variable Working Capital

It is the additional type of working capital kept for meeting the fund requirement during the peak seasonal demand of the year. Businesses borrow funds to meet increased capital requirements. It is the temporary increase in working capital that is only applicable for businesses that are impacted by seasons. 

This capital is the difference between networking and permanent working capital. Here, the business earnings is not similar to the salary earnings of employees. Due to the shorter duration during which a business can earn money, such professionals leverage the season. 

3. Special Variable Working Capital

It is a type of working capital that is required by any business to finance any unforeseen and exceptional circumstances. For any situations such as natural disasters, fire incidents, and earthquakes, this capital is used. It is a temporary working capital that is considered to be a type of variable working capital. 

4. Net Working Capital

It is a type of working capital through which current assets exceed current liabilities. Here, current assets are the accounts receivable, sum of cash, raw material, and finished goods inventory. Current liabilities include accounts payable. It is calculated using the line items from the balance sheet of a business. 

5. Negative Working Capital

If the company has large net working capital requirements, it has the capability of covering its current obligations. Negative working capital refers the situation where current liabilities exceed the current income and assets. It occurs when the business makes larger purchases such as buying new products, stock investment, and purchasing new equipment. 

The negative working capital cycle occurs when a business collects money faster than it is required to pay the bills. A business must understand if it can afford to use the negative working capital to cover payroll, supplier’s bills and regular expenses without risk.

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