Accounting

What is Working Capital Requirement

What does negative working capital requirement mean?

Working capital requirement – What is a working capital requirement?

The working capital requirement refers to the funds the company needs to finance its operations. Knowing the working capital concept is essential for any entrepreneur wishing to ensure that his business is financially sound. Working capital requirement (or WCR) is the amount required to finance a company’s production activity over a business cycle.

What is the need for working capital?

The working capital requirement shows the financial health of the company in the short term, over a business cycle or an accounting period. Specifically, it measures the company’s ability to fund its own business cycle internally, without the need for external sources of financing. The existence of a WCR arises from a simple shift in cash flow: indeed, the moment when you regulate your supplier rarely corresponds to the moment when your customer pays you.

It is therefore necessary to be able to absorb this phase of floating, where you have been debited by your supplier but not credited by your client.

Let’s say that you have to pay your suppliers within 2 weeks, but that your customer pays you only after 3 weeks: the cash has a latency period of one week. During this week, the cash of your company is decreasing since you had to pay your suppliers without having been paid by your client.

On the other hand, the need for working capital is linked, for example, to the company’s storage needs. The lower the inventory turnover ratio, the greater the need for financial means (and therefore WCR) to finance its storage costs.
How to calculate the working capital requirement?

The working capital requirement (WCR) is calculated from the balance sheet. There are two calculation formulas, a simplified formula and a longer one.

The simplest formula for calculating working capital requirements is:

WCR = inventories + receivables – non-financial liabilities

Most receivables are trade receivables.

Debts are mostly debts to suppliers.

The WCR corresponds to the difference between the jobs of the holding and the resources of the holding, hence the second formula:

WCR = farm employment – farm resources

Operating expenses corresponding to inventories and work in progress, trade receivables, discounts, other receivables, prepaid expenses.

Operating resources are the various short-term, non-financial debts.

We can also use the following formula, which comes to the same, and is also calculated from the balance sheet:

Current assets (excluding cash) – current liabilities (excluding financial liabilities)

What does negative working capital requirement mean?

The working capital requirement should preferably be negative. It should be reduced to the minimum possible, including if it is already negative. A negative WCR means that the company is in good financial health and has enough money to be able to honor its short-term debts.

In other words, the funds available to the company allow it to fully finance its next cycle of operations and its short-term jobs. For example, for certain activities such as mass retailing, WCR is always negative.

Indeed, mass-market companies normally pay their suppliers after delivery. The company then benefits from an inflow of cash.

What does positive working capital requirement mean?

A positive WCR indicates that the debts of the company’s customers are not sufficient to cover short-term assets and that external financing will be required. Most companies have positive WCR, meaning that the funds needed to finance operations are higher than the operating resources available to the company. As a result, the company must find additional funds to finance its operating cycle.

Differences between working capital and working capital requirement

The term “working capital requirement” refers to current and short-term resources and jobs, or to the operating cycle. We talk about “working capital” when we talk about stable jobs and resources, that is, long-term, or more than one year.

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