What is Working Capital?

In plain words if I define Working Capital I would like to say that it is the essential capital for running the business and importance of which can be compared with importance of blood required for functioning of our body.

Let me explain. Think that you have decided to start business of grocery shop. You have only USD 100,000 in Cash. You purchase a fully furnished ready for business shop with USD 100,000 at an attractive location where you have analysed that it will be convenient for the people to drop in and make purchase for their day to day needs.

Note: With purchase of shop you have converted your Cash Asset into a Fixed Asset.

Before you commence your business, you need to fill the shop with various grocery items. Based on your procurement list, it requires USD 80,000 for purchasing all these items. Further, you also require USD 5,000 for your day to day Cash needs for running the shop.

You have only USD 50,000 in your account i.e. you are short of USD 30,000 for purchasing the required Stock and USD 5000 for meeting your day to day needs (i.e. total short fall USD 35,000). You speak to the wholesale grocery Vendor and tell him about your Cash shortfall problem.  He agrees to give you credit equivalent 20% of your total purchase (i.e. USD 80,000) which works out to USD 16,000 for 1 month credit period i.e. you have to pay him USD 16000 at the end of 1 month from the date of purchase. Even with this arrangement, You are still short of USD 19000 (i.e. USD 80,000 plus USD 5000 minus USD 50000 minus USD 16000). 

Note : (1) You converted Cash USD 50000 into Grocery items worth USD 80,000. (2) You created a short term (i.e. 1 month) liability in the form of Unpaid Creditor.

You speak to your Banker for lending you USD 19000, and the Banker happily agrees to lend you USD 19000 at the rate of interest of 10%  p.a. for 1 year period provided you give him security of grocery Stock which will be lying in your shop.

Note : You created Short Term liability in the form of Debt of USD 19000. This Cash you use for 1. Payment of USD 14000 to Vendor 2. Keep Cash in business USD 5000.

With the above arrangement in place your Shop starts on January 01. Let’s say by January 31, you have sold 90% of the item with 25% profit margin.

On January 31, you have the following requirements:

A1. Payment of unpaid USD 16000 to grocery Vendor

A2. Interest Payment of USD 158.33 to Bank

A3. Shops electricity bill payment USD 500

A4. Your fixed remuneration USD 500

A5. New grocery Stock purchase requirement of USD 72000

Total payment requirement (sum 1 to 5): USD 89158.33

By selling the grocery items during the month, you have generated following Cash:

B1. Sales in Cash (90% of the total Stock): USD 72000

B2.  Add profit on Sales (25% of the Sales): USD 18000

Total Cash generated: USD 90,000

Note : Don’t’ forget that you have another USD 5000 as Cash in business for meeting day to day needs.

You use this Cash as following:

C1. Payment of items A1 to A4 i.e. : USD 17158.33

C2. You discuss with your Vendor to continue the relationship of 1 month Credit and he also happily agrees since you have fulfilled your promise by Cash payment at the end of the month, so you pay him 80% of your fresh purchase requirement (item A5 above) i.e. : USD 57600

Total Cash Payment: USD  74758.33

Cash left with you: USD 90,000 plus USD 5000 minus USD 74758.33 equal to USD 20241.67

From all the above management and work of 1 month, at the end January 31, your Shop business has following it owns and owes:

1. Cash: USD 20241.67 (Shop’s Current Asset) (Remember that apart from profit this Cash also includes USD 5000 for meeting day to day business needs)

2. Old Stock: USD 8000 (remember you had sold only 90% of the total Stock of USD 80,000 !) (Shop’s Current Asset)

3. New Stock purchased: USD 72,000 (Shop’s Current Asset)

4. Shop with value of: USD 1,00,000 (Shop’s Fixed Asset)

4. Short Term Debt (Bank Loan): USD 19000 (Shop’s Current Liability)

5. Unpaid Creditor: USD 14400 (Shop’s Current Liability)

7. Money the Business Owes to You (remember your Cash investment of USD 1,00,000 plus USD 50,000) : USD 1,50,000 (Shop’s Long Term Liability)

8. Your profit generated from 1 month’s successful operations: USD 16841.67 (Shop’s Long Term Liability)

Total Current Assets: USD 1,00,241.67

Total Fixed Assets: USD 1,00,000

Total Assets: USD 200241.67

Total Current Liabilities: USD 33400

Total Long Term Liabilities: USD 150000

Total Long Term Liabilities (Retention of Profits): USD 16841.67

Total Liability: USD 200241.67

From the above, you will be amazed with some of items named as Current Assets, Current Liabilities, Fixed Assets, and Long Term Liabilities. What are these jargons? If you analyze the nature of these items, you can simply, conclude as following:

Current Assets: Simply the grocery items lying in the Shop which can be converted in to Cash at any point of time (So you can say at least within time period of one year), and the Cash maintained by the Shop.

Current Liability: Unpaid Vendor and Debt from Bank to be repaid shortly (here also you can say within maximum time limit of 1 year. Remember the loan period stipulated by your Banker, 1 year!)

Fixed Asset: Assets procured on permanent basis which cannot be sold by business for generating the regular sales. But these assets are required as basic block/foundation being critical for business. Remember, the first thing you required for the Business: ‘Shop’ the foundation. You will not be selling the Shop for generating the sales. Sales will come from selling the grocery items.

Long Term Liability: You will notice that these are liabilities that business does not need to repay immediately or in near future (You can say repayable at least after 1 year. Are you going to withdraw your investment of USD 1,50,000 plus your profit immediately? Off course not, unless you plan to close the Business by selling it to someone else!

So, from the above what are critical items for business to handle by putting heart and soul? Definitely it is the current/immediate needs of the Business. And what are these current needs? Off course the current assets and current liabilities which the business need to address immediately because Business cannot 1. afford to be short of grocery items (i.e. Current Assets) otherwise customer will be diverted to competitors if they don’t get the needed items at your Shop 2. Displease the Vendor by not making payments on time or defaulting to the Banker, otherwise the Vendor may not allow supply on credit basis or Banker may withdraw the loan.

How you have handled this criticality? See are what your Currents Assets and how did you procure them?

Your Current Assets: USD 100241.67 (comprises Stocks and Cash)

Your Current Liabilities: USD 33400 (comprises unpaid Vendor USD 14,400, Bank Loan for Stocks USD 14,000 and Bank Loan for meeting day to day Cash need USD 5000)

Difference: USD 66841.67 (How this gap is funded? From your Long Term Investment in the business for procurement of Stock: USD 50,000 plus your Cash profit of USD 16241.67 kept in the system)

From the above, you will appreciate that Stocks and Cash is something very critical to run your Shop. If no Stock and Cash, Shop cannot function! So, it is this capital required for maintaining the Current Assets which is must for running the business i.e. the capital of USD 100241.67 which is called as Gross Working Capital.

The difference between Current Assets and Current Liabilities (i.e. USD 66841.67) is called Net Working Capital or Net Current Assets.