Working capital management is a critical component of business finance. Having a sound understanding of the different kinds and sources of working capital can empower companies to make informed financial decisions, ensure liquidity, and drive operational efficiency. This article explores the key types and sources of working capital in the Indian context.
Kinds of working capital
Working capital is broadly classified into different types based on the time period and purpose for which the capital is required. Understanding these classifications is important for effective working capital management. The main kinds of working capital that businesses need to be aware of are:
- Permanent working capital: Also known as fixed working capital, this refers to the minimum funds a company needs to conduct regular business operations. It is the long-term capital required to sustain day-to-day activities.
- Temporary working capital: Temporary working capital fluctuates with business needs and is further classified into:
- Seasonal working capital: Additional funds required to meet increased demand during peak seasons. Once the seasonal demand declines, this capital is reduced.
- Special working capital: Extra capital needed to meet special business needs such as launching a new product. It is temporary and event-driven.
- Reserve working capital: A financial cushion maintained to address unforeseen contingencies and emergencies.
- Gross and net working capital: Gross working capital considers the firm’s total current assets. Net working capital is the difference between current assets and current liabilities. It represents the liquid assets available after meeting short-term debt obligations.
Sources of working capital
Companies have access to a range of sources to raise the working capital they need for smooth business operations. Both internal and external options are available. Some of the key sources that businesses commonly utilise to finance their working capital requirements include:
- Internal sources: Working capital can be generated from within the business itself through various internal means rather than external borrowings. Some of the key internal sources that companies rely on to finance working capital needs include:
- Retained earnings: Saving and reinvesting business profits rather than distributing dividends. A cost-effective source of capital.
- Depreciation funds: Setting aside fixed asset wear and tear allowance rather than treating it as an expense.
- Reserves: Funds from sale of assets, decreasing capital, or decreasing revenue expenditure.
- Owner’s capital: Additional capital injected by business owners.
- External sources: In addition to utilising internal accruals, working capital can also be obtained from external sources through different financing options. Some popular external sources that businesses tap into to fund their working capital requirements include:
- Bank finance: Overdrafts, cash credits, working capital loans. Useful for managing short-term needs.
- Trade credit: Credit extended by suppliers of goods and services. Helps augment working capital.
- Customer advances: Mobilising advance payments from customers. Improves liquidity.
- Factoring: Selling receivables to a third party at a discount to raise short-term capital.
- Commercial Paper: Unsecured short-term debt instruments issued by firms to investors.
- Inter corporate deposits: Borrowing from other businesses. An accessible and fast option.
Working capital management requires understanding key types like permanent, temporary, gross, and net working capital. Companies can tap diverse sources such as internal accruals, external borrowings, and mobilising advances to ensure optimal working capital. A robust working capital strategy is indispensable for financial health and business growth.