1. About Working Capital Reserve
2. Sources of Working Capital
3. The Operating Cycle
4. Types of Working Capital

A working capital reserve is the available working capital that exceeds the regular working capital. The reserve is working capital kept available for unexpected situations. It is also used to take advantage of opportunities quickly.

About Working Capital Reserve

The working capital reserve shows on the balance sheet and can be used to offset capital losses. This may include:

  • Long-term projects.
  • Mitigating capital losses.
  • Other long-term contingencies.
  • Issuing stock that surpasses par value.
  • Redemption of debentures.
  • Reissue of forfeited shares.

The reserve is created out of capital profits. This can include an upward revaluation of the company assets that presents the company's current market value. The process of revaluation may be based on profits, appreciation, or the sale of assets. Sums that have been allocated to a capital reserve account are permanent as investments. This means the reserve cannot be used to pay dividends.

Since capital reserves are created from non-trading activities, it cannot be used as an indicator of how well the business is operating. In other words, the capital reserve is not part of the businesses trading or operational activities.

Sources of Working Capital

Several options are available that serve as sources of working capital.

  • Equity: For a new business that has not yet established itself and become profitable, equity funds are a short-term option to secure working capital needs. Funds may be acquired from a third-party investor, friend or family member, or your own personal resources.
  • Trade creditors: If you have established the business as one that pays on time with your trade creditors, these businesses may provide short-term working capital that enables your business to take on more or bigger orders.
  • Factoring: New businesses often use factoring as a short-term resource. With this process, a factoring company will buy your account receivable and is then responsible for collecting. It is a more expensive process but an option for businesses just starting out and in need of working capital.
  • Line of credit: A line of credit is a source of short-term funding that allows you to repay the loan once you've collected payment of the outstanding accounts receivables. These usually have a timeframe of one-year with the expectation that it will be paid off sometime during that year to ensure the usage of the funds is for short-term needs only.
  • Short-term loan: If your business does not qualify for a bank's line of credit, a one-time, short-term loan may be more accessible. These usually have terms for less than a year and work well as a backup while waiting for accounts receivables or to fund seasonal inventory.

The Operating Cycle

In business, the operating cycle analyzes accounts payable, accounts receivables, and inventory. This is accomplished in terms of days. This means an account receivable is analyzed in terms of the average number of days it will take to collect on the account.

The inventory is analyzed from the point of entry to your location to the point it is sold and converted into either cash or an account receivable. This means it is analyzed by an estimate of how many days it takes to turn the product into a sale. Accounts payable is analyzed according to the number of days it takes for you to pay a supplier's invoice. Generally, most businesses will need short-term capital, whereas a larger firm will need a larger buffer of working capital.

Types of Working Capital

The working capital of a business is divided into two types: balance sheet view and operating cycle view. With the balance sheet view, the working capital is broken down into gross working capital and net working capital. For the operating cycle view, working capital is divided into permanent and temporary working capital. Under the operating cycle, the permanent working capital is divided, yet again, into seasonal and special capital.

Temporary working capital is filtered into regular and reserve working capital. Temporary working capital is determined by the difference between the net working capital and the permanent working capital. Seasonal working capital is a temporary increase in the working capital generated by a specific season that may be relevant to the business.

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