When it comes to short term financing of a business, monitoring working capital is very vital. In this lesson and a series of other articles, we will discuss working capital management in detail. In this article, the focus is on the meaning of working capital and key points to help understand the concept.
What is working capital?
Working capital is the fund or capital necessary to run the day-to-day operational activities of a business.
It can also be defined as the capital used to fund a business operating cycle.
Furthermore, working capital can be defined as the capital used to fund the business obligations immediately these obligations are due.
Key Explanations to note
Working capital is part of the capital. If you’re starting a new business, you will normally introduce funds called capital to start the business. This capital called startup capital will be used to rent the store you use for your business, buy the van to distribute the goods if necessary, acquire office equipment, and also buy inventory.
However, you will also need to set aside cash from this startup capital which is known as working capital. It is the working capital you will use to meet every daily operation of the business before you start making sales.
Working capital is utilized for day-to-day business operations. The cash you have set aside as working capital is for your daily operations. Such as buying of fuel, buying credits on your business phone, transport expenses as well as the purchase of inventory.
Working capital is used to fund the business operating cycle. The operating cycle explains how cash changes form. Cash will be used to purchase inventory, this inventory will be sold out for cash or on credit. If it is sold for cash, the period for the operating cycle is reduced. However, if the inventory is sold on credit, this will prolong the operating cycle.
Why? Before credit sales become cash, it takes a longer period. Many customers may default in paying their debts, while others may be encouraged to pay their debts through incentives such as cash discounts. As a result of the debt, the amount available as working capital may be diminished.
Working capital is also used to meet the present obligations of the business. This includes repayments of loan and its interest, payment of taxes among other things. When a business can meet its present obligations, such business is referred to as a liquid business. Or the business has liquidity.
To wrap it up, working capital is required to meet daily operation expenses, meet present obligations, and fund the operating cycle of the business.