Internal sources of finance come from within the business. Reductions in Working Capital belong to internal sources of finance.
4. Reductions in Working Capital
Working Capital is the money kept in the business to finance the day-to-day running expenses of the business organizations, and to pay short-term debts. Those companies with a long cycle of capital turnover will be able to benefit the most from reductions in Working Capital.
Why businesses need Working Capital?
Working Capital helps businesses in running smoothly and efficiently every day.
All businesses need Working Capital to pay for raw materials and to build up inventory, to pay production workers, to offer trade credit to customers, to pay utility bills, to pay back overdraft to the bank, etc. So, all businesses need to keep that kind of money available to pay for daily operations. Money is important.
It also helps to maintain the company’s goodwill. If external parties learn that the business’s Working Capital is insufficient, they will most likely not be interested in cooperating with that company.
Working Capital also gives the company strong bargaining power. In business and in life, cash is king and companies with sufficient Working Capital can bargain and get things done according to their terms rather than letting others to set the terms.
However, when the business decides to reduce the amount of Working Capital, then additional money can be released to be used by the business as a source of finance. So, businesses may be able to use some of their Working Capital to raise additional funds for other long-term projects.
How to calculate Working Capital?
Working Capital is calculated as:
Working Capital = Current Assets – Current Liabilities
Current Assets are liquid resources belonging to a business that can be converted into cash within one year. Current Assets include:
- Cash. Money kept as cash in the business, or in the corporate bank account.
- Inventory. All the supplies of raw materials, semi-finished goods and finished goods. In short, unsold stock that is being stored waiting to be shipped to the customers.
- Debtors (Trade Receivables). A debtor is a legal entity that owes money to another party. Customers who owe money to the business as they have purchased goods on credit.
Current Liabilities refer to the money that a business needs pay to others within one year. Current Liabilities include:
- Overdraft. Overdrawing the bank account and paying it back.
- Creditors (Trade Payables). A creditor is a party that has a claim in the services of the second party. Suppliers from whom the business purchased on trade credit.
- TAX. Paid the government on the amount of Net Profit Before TAX.
- Short-term bank loan. Paid to the bank on any borrowings shorter than 12 months.
- Dividends. Paid to shareholders monthly, quarterly, biannually or annually as decided and approved by The Board of Directors.
Reductions in Working Capital
So, in order to reduce Working Capital, the business should reduce Current Assets, or increase Current Liabilities.
How much can the business raise by reducing Working Capital?
The amount of finance raised by reducing Working Capital depends on the size of the business. Larger businesses are likely to have higher levels of inventory and credit sales than small businesses. So, these companies can raise more finance in this way.
