Working Capital definition – No organization can run successfully without capital available, both for short term needs and long term needs. According to the Working Capital definition, capital borrowed for short term needs to fulfil the deficit in the cash conversion cycle is known is working capital. In accounting terms, working capital can be defined as the difference between short term assets and short liabilities, also known as current assets and current liabilities.
Some industries are strongly dependant on the current rate of the US Dollar vs their local currency. The past few months have seen the strengthening of the dollar, which would mean that imported products like fuel would cost a lot more than what they used to cost before. This can cause a severe dent on an organization’s financials.
Working Capital definition – Going into the details
Every business has a gestation period, where cash invested takes time to convert into cash again. Let us take an example of a manufacturing unit to understand this better.
XYZ has a factor that employs 100 people; it has hugely invested into land, buildings and machinery too. However, the investments on fixed assets do not give immediate yield, and do not require constant investment either. Hence, they are known as fixed assets. According to the Working capital definition, only current assets and current liabilities are to be considered for understanding working capital. Hence, the salaries of workmen, the cost of fuel for running the factory, electricity, cost of raw material etc, are investments to be made even without a penny coming in. The company might have some cash surplus, and hence the difference between those surpluses and the immediate expenditure is known as working capital.
Working Capital Definition – A Holistic Approach
While working capital is of immense necessity to an organization, being too dependent on short term lending can be disastrous to the organization in the long run. One factor that needs to be kept in mind is that short term capital attracts higher rates of interest than long term capital. Your loans on fixed assets like land or building might attract half of the interest you might need to pay for short term credit. Since, short term credit is riskier for the financing organization; they tend to squeeze companies with such a requirement.
Yet, no organization can run away from borrowing for the short term. Whether you run a manufacturing unit or a Human resource procurement agency, there will be credit that you will extend to clients, and some of them will misuse that facility and extend it as per their terms.
Also, you might have invested excessively in raw material, which is not getting converted into the finished product. Another situation that can affect your working capital definition of the organization is the fluctuating foreign currency.
Working Capital Definition- A conclusion
Every organization would not want to pay extra money for getting a loan for working capital needs. If the financial planners make a proper estimate of their working capital definition, such a need would be reduced.