Lending
How to Calculate Your Working Capital Requirement for Business
Working capital is the lifeblood of a business, ensuring that day-to-day operations run smoothly. It represents the funds available for the company to cover its short-term liabilities and operational expenses. Calculating your working capital requirement accurately is essential for maintaining liquidity and ensuring the stability of your business.
Working capital is the difference between a company’s current assets and its current liabilities. Current assets include cash, accounts receivable, inventory, and other assets expected to be converted into cash within a year. Current liabilities encompass obligations such as accounts payable, short-term loans, and other debts due within a year. The fundamental principle behind working capital is to ensure that a business has enough current assets to cover its current liabilities.
Calculating Working Capital Requirement: Step by Step
Let’s understand the significance of working capital through a step-by-step process of calculating your business’s working capital requirement.
Step 1: Gather Financial Data
To begin, collect the necessary financial information from your balance sheet. You’ll need the figures for current assets and current liabilities. Current assets typically include:
- Cash and cash equivalents
- Accounts receivable (money owed by customers)
- Inventory
- Short-term investments
Add up the values of all your current assets. This sum represents the total amount of capital tied up in short-term assets. Current liabilities usually include:
- Accounts payable (money owed to suppliers)
- Short-term loans and debts
- Accrued expenses
Sum up the values of all your current liabilities. This figure represents the amount of money you owe to various parties within the next year.
Step 2: Calculate Working Capital
Subtract the total current liabilities from the total current assets. The resulting number is your working capital. The formula is:
Working Capital = Total Current Assets – Total Current Liabilities
A positive working capital indicates that your business has more assets than liabilities to cover short-term obligations, which is generally a healthy sign. Conversely, a negative working capital implies that your liabilities exceed your assets, potentially indicating financial distress.
Step 3: Analyze and Interpret
Interpret the calculated working capital in the context of your business operations. A high working capital might indicate that you have excess funds tied up in non-productive assets, while a low working capital might suggest potential liquidity issues.
Drawing Power Calculation:
-
- Drawing power is the amount that a customer can withdraw from the total limit sanctioned to them by the lending bank.
- The drawing power amount is calculated as the per margin rate of the lending bank, usually after deducting margin from primary security for working capital (usually cash credit limit), i.e., “Stock – Creditors + Book Debts.” Typically, it is 75% in case of paid stock and 60%-75% in case of Book Debts. In case of Export Sales, it is 90%, also if the limit is under PCFC arrangement.
- The amount eligible for drawing power can change every month and is a fluctuating amount, depending on the closing value of the stock in the inventory statement provided by the company at the end of that period (generally every month or every quarter).
Calculation of Drawing Power: (Rs in Crore)
| Particulars | Value as per Stock Statement | Margin% | Margin Amount | Advance value |
|---|---|---|---|---|
| i) Raw Material | 4.50 | |||
| Less: Unpaid Stock i.e., Sundry Creditors- Trade | 2.00 | |||
| Net Value of RM | 2.50 | 25% | 0.625 | 1.88 |
| Stock in Process | 1.25 | 25% | 0.3125 | 0.94 |
| Finished Goods | 0.00 | 25% | 0.000 | 0.00 |
| Total Value of Inventory (A) | 3.75 | 0.9375 | 2.81 | |
| ii) Receivables (Within sanctioned cover period) (B) | 6.50 | 40% | 2.60 | 3.90 |
| DP (A+B) (C) | 6.71 | |||
| FBWC limits sanctioned by Banking System (D) | 5.50 |
Conclusion of Drawing Power and Utilization of Limit:
Drawing Power Utilization is as follows:
If the DP limit is more than the sanctioned limit, the customer can utilize the full sanction letter limit. However, if the DP limit is less than the loan sanction letter limit, the customer can utilize the limit up to the DP limit.
In the example provided:
- Sanctioned limit is Rs. 5.50 crore.
- Drawing power is Rs. 6.71 Crore.
Thus, the customer can utilize the full limit of Rs. 5.50 crore.
Points to Notes:
- In the calculation, Debtors are usually taken between 90 to 120 days, and debtors above that period are not considered in DP Calculation. This period is mentioned in the Sanction Letter (check from the sanction letter).
- C. Stock has to be excluded from the Stock figure.
- If any Advance has been taken from the Customer, then the net book debt should be considered in the calculation.
- Insurance of Stock should be based on the value mentioned in the stock statement.
For example, if insurance of stock is taken for Rs. 1.50 Crore and as per the latest stock statement, the value of stock is Rs. 3.75 Crore, then insurance of the balance amount should be considered. (Discuss with the banker for the same).
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