Capital and Working Capital

Capital and Working Capital

Capital and Working Capital
Capital and Working Capital

Every business requires Capital and Working Capital to fulfill all its commercial needs, whether it’s gathering resources or investing capital in day-to-day activities. Active capital is often referred to as short-term capital decisions.

Active capital revolves around two crucial components of a business or enterprise, which are current assets and current liabilities. Current assets are those capable of converting into cash within one year.

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Additionally, they are highly liquid and are referred to as the operational assets of the business. Examples include bank balances, cash in hand, short-term investments, receivables, and prepaid expenses.

Capital and Working Capital

Another component of active capital is current liabilities. Current liabilities represent the sum of payments expected to be made within a year. Examples include bank overdrafts, outstanding expenses, and others.

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Net active capital is the difference between a company’s current assets and current liabilities. It reflects the liquidity of a business and also indicates its operational efficiency. The better the active capital, the healthier the short-term financial health of the business.

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The concept of active capital is straightforward. It is the capital that a business utilizes to meet its daily expenses, often considered the most liquid part of the total capital. Active capital is also known as Net Working Capital (NWC).

It is calculated by comparing the current assets and current liabilities on the balance sheet. The formula for calculating net working capital is:

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(Net Working Capital)=Current Assets – Current Liabilities

This formula helps gauge a business’s ability to manage its current expenses and provide financial support for future expenditures. Net working capital or active capital is crucial for assessing a business’s short-term financial health, indicating its ability to operate and sustain itself.

Types of Active Capital-Capital and Working Capital

Active capital can be categorized based on different criteria:

  1. Based on Concept:
    • Gross Active Capital: Considered as the total current assets.
    • Net Active Capital: Calculated by subtracting current liabilities from current assets.
  2. Based on Time:
    • Permanent Active Capital: When the life of active capital is one year, and a portion of the investment is permanent, it is termed permanent active capital.
    • Temporary Active Capital: Temporary or circulating active capital fluctuates over time and is not invested permanently.

The Definition of Active Capital

Active capital can be defined as the difference between current assets and current liabilities. It represents the portion of capital that a business uses to fulfill its daily expenses and is considered the most liquid part of the total capital. Active capital is also known as Net Working Capital (NWC).

Factors Influencing Active Capital

Several factors influence active capital, including the nature of the business, technological changes, seasonal or cyclical variations, length of the production cycle, availability of loans, customer payment habits, and the estimated growth and expansion of the business.

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How Business Nature Affects the Need for Active Capital

Large-scale businesses often require more active capital compared to small-scale businesses. This is because larger businesses typically have higher operational expenses, a larger customer base, and more extensive supply chains, necessitating greater liquidity.

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Summary, Capital and Working Capital

Every business aims to maintain an optimal active capital ratio to ensure financial stability and meet its operational needs. The need for additional active capital arises during periods of reduced cash flow, ensuring smooth operations during challenging times. Additionally, having extra active capital enables a business to invest more in resources, take advantage of bulk purchasing discounts, and excel in a competitive market.

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