Each and every business, the same as every human being, must be able to pay for its day-to-day expenses. In order to finance all of those short-term expenses, the business must have sufficient Working Capital.
For people, this includes buying food, visiting a doctor, paying for transportation, paying utility bills, etc.
For businesses, this includes buying raw materials to build up inventory, paying production workers’ wages, paying utility bills, buying fuel for vehicles, fixing the machinery, etc. Also, in the world of business, it is very common to offer customers trade credit, so they can buy now and pay later.
What is Working Capital?
Working Capital refers to liquid assets available to be used for the daily running of a business. It shows the funds that are available for a business immediately to pay for its urgent costs and daily expenditure.
The importance of Working Capital
Working Capital is the capital needed to finance the everyday running expenses and pay short-term debts of a business. It is the ‘lifeblood’ of a business organization.
1. Working Capital maintains liquidity
Working Capital helps businesses in running smoothly and efficiently every day by measuring the liquidity of a business. Liquidity is the ability of a firm to pay its short-term debts. Current Ratio and Quick Ratio (Acid-Test Ratio) are used to assess the liquidity. The term liquidity also refers to how easily an asset can be turned into cash. Highly liquid assets include Cash and those that can be converted into cash quickly and easily without losing their monetary value such as Debtors. Inventory are considered as a less liquid asset than Cash and Debtors as they cannot be changed into cash as easily or quickly.
2. Working Capital prevents liquidation
A lack of Working Capital means that the firm has insufficient Current Assets to fund its routine operations. A business which does not have enough Working Capital will be illiquid – unable to pay its immediate or short-term debts. This means the business could be forced to stop trading. What happens in cases such as this?
- The business is able to borrow money to become liquid. If this happens, the business may have to borrow the finance required. However, it will have to pay interest on the amount borrowed and this increases the business’s Fixed Costs.
- The business is unable to borrow money and remains illiquid. Either the business raises finance quickly – such as an overdraft – or it may be forced into ‘liquidation’ by its creditors the firm owes money to. If, however, the business is unable to borrow the finance required, then it may fail. Liquidation happens when a firm cease trading and its assets are sold for cash to pay suppliers and other creditors.
3. Working Capital ensures good reputation
Working Capital helps to maintain the company’s goodwill – reputation. If external parties learn that the business’s Working Capital is insufficient, they will most likely not be interested in cooperating with that company.
4. Working Capital gives bargaining power
Working Capital also gives the company strong bargaining power. In business and in life, cash is king. Companies with sufficient Working Capital can bargain and get things done according to their terms rather than letting others set the terms.
5. Working Capital can serve as long-term finance
When the business decides to reduce the amount of Working Capital, then additional money can be released and used by the business as a source of finance. So, businesses may be able to accommodate some of their Working Capital to raise additional funds for long-term projects.
How to calculate Working Capital?
In accounting terms Working Capital equals to Current Assets minus Current Liabilities. It can be calculated based on Balance Sheet by using the following formula:
Working Capital = Current Assets – Current Liabilities
Working Capital can also be referred to as Net Current Assets.
Current Assets
Current Assets are cash and any other liquid assets that are likely to be turned into cash within the next 12 months, or the date of the next Balance Sheet. Current Assets are an important source of liquidity for the business to keep it running on daily basis.
Examples of Current Assets:
- Cash. This includes cash in hand and cash in the corporate bank account.
- Debtors (Accounts Receivable). These include money owed to the business by customers who have bought products on credit. They were given trade credit, or have paid by cheque or credit card.
- Inventories. This is value of all unsold stock being hold by the business. Inventories include raw materials, work in progress and finished goods ready to be shipped to customers.
Current Liabilities
Current Liabilities are all debts of the business that have to be paid back within the next 12 months, or the date of the next Balance Sheet. Current Liabilities along with Current Assets are an important source of liquidity for the business.
Examples of Current Liabilities:
- Overdraft. This is the obligation payable back to the bank within the current accounting period. Overdraft carries very high interest.
- Creditors (Accounts Payable). These include the amount of money a business owes to its suppliers for goods it bought on credit. Suppliers gave the business trade credit.
- Short-term Loan. This includes the amount of short-term debt as any bank loans that were given to the business for a period of time 12 months or shorter. Usually, it is in the form of a line of credit.
- TAX. This includes any amount of TAXes owed to the government by the business. The actual amount of TAX can be seen in Profit and Loss Account (P&L Account). TAXes are usually paid once a year.
- Dividends. These include any unpaid dividends to shareholders. Dividends are usually paid quarterly or sometimes monthly.
Where does Working Capital come from?
Virtually no business could survive without Current Assets. Although some business owners refuse to sell any products on credit, so there are no Debtors (Accounts Receivable). This is very rare for businesses beyond a certain size. Where does the capital come from to purchase and hold these Current Assets?
Most businesses’ funds for Working Capital come from Short-Term Sources of Finance. Mainly from Overdraftsand Creditors (Accounts Payable). However, it would be unwise to obtain all of the funds needed from these sources only.
- First, they may have to be repaid at very short notice, meaning the firm is again left with a liquidity problem.
- Second, it will leave no Working Capital for buying additional stocks or extending further credit to customers when required.
Additional funds that can be used for Working Capital include Personal Funds, Retained Profits, Sales of Fixed Assets, Family and Friends, Debt Factoring and Microfinance Providers.
How does Working Capital ‘work’? The Working Capital Cycle
Cash will leave the business when it pays for expenses such as supplies of raw materials, workers’ wages, rent, TAXes, interest payments on bank loans, etc. For most businesses, there is a delay between paying for costs of production and receiving the cash from selling products. This is because the production process always takes time – sometimes shorter, sometimes longer. Consider the time lag from receiving an order for an airplane and actually receiving the cash once the airplane is finally handed over to the customer (the airline).
The interval between cash payments for costs of production and cash receipts from customers is known as the Working Capital Cycle. The delay means that businesses must manage their Working Capital very carefully to continue functioning.
The length of the Working Capital cycle depends on the level of inventories held by a business, how long it takes to produce goods for sale, how quickly the business finds the buyers for its products, the length of the credit period customers are given and how quickly suppliers are paid.
Sometimes, a business has a lot of stock which cannot be easily turned into cash and customers demand a lengthy credit period meaning that the business will not receive the cash payment until the credit period is over. Businesses usually sell their products on a credit basis receiving cash from the sale at a later date, for example 30, 60 or 90 days after delivery to the customer. However, businesses still need to pay for their on-going costs such as supplies of raw materials, workers’ wages, rent, TAXes, interest payments on bank loans, etc.
So, there must be enough cash coming into the business to pay the expenses and other debts. Sometimes it happens that businesses do not manage Cash Inflows and Cash Outflows effectively. And they end up not having enough cash to pay for their expenses and debts.
How much Working Capital is needed in a business?
Managing Working Capital efficiently is vital for all businesses.
The required amount of Working Capital needed by a business depends on the length of the Working Capital Cycle – the amount of time it takes from buying raw materials, converting these into goods for sale, finding buyers for the finished goods and finally receiving cash payments from customers.
A. Less Working Capital: The shorter the time period from buying materials to receiving payment from customers, the lower will be the Working Capital requirement. To receive more trade credit from suppliers than is given to customers is to reduce the need for Working Capital. It is because trade credit received by the business from suppliers will lengthen the time before stock bought has to be paid for.
B. More Working Capital: The longer the time period from buying materials to receiving payment from customers, the higher will be the Working Capital requirement. To give more trade credit to customers than is received from suppliers is to increase the need for Working Capital. It is because trade credit given by the business to customers will lengthen the time before a sale is turned into cash.
Is Working Capital sufficient?
Sufficient Working Capital is essential to prevent a business from becoming illiquid – unable to pay its short-term debts.
A common measure of liquidity is Current Ratio. Current Ratio deals with a firm’s liquid assets and Short-term Liabilities – its Working Capital used to run daily operations. Current Ratio compares the values of Current Assets with Current Liabilities. It reveals whether a firm is able to cover its short-term debts using its liquid assets.
Current Assets represent things owned by the business which are already in the form of Cash, or which are easy to be converted into cash within the next 12 months. Current Assets are important to a business because they indicate how much cash a business has access to in order to meet its short-term obligations. Current Liabilities are the short-term debts of a business, which are expected to be paid in the near future within the next 12 months.
It is important that the level of Current Assets is greater than the level of Current Liabilities. Proper Current Ratio is between 1.5 and 2 which is generally safe. If Current Ratio is around 1.5, then the firm has safe liquidity level as its Working Capital is appropriate to cover its Current Liabilities. There is no particular result that can be considered a universal guide to a firm’s liquidity – much depends on the industry.
Current Ratio should be no less than 1.5, otherwise there is a risk of running out of cash. The firm might experience Working Capital difficulties, or even experience a liquidity crisis. Liquidity crunch is a situation where a firm is unable to pay its short-term obligations.
Current Ratio should be no greater than 2 since this suggests that the business has too much cash tied up in unprofitable assets. Potential lenders, suppliers and investors are likely to be interested in a firm’s Current Ratio to reduce the exposure of risk, since this ratio measures the ability of a firm to cover short-term debts with its Current Assets.
What if Working Capital is too high?
When is Current Ratio too high? If Current Ratio is above 2, then the firm has too much unnecessary liquidity as its Working Capital is way too much to cover its Current Liabilities. A Current Ratio above 2 suggests that there is too much Cash, too much Debtors (Accounts Receivable) and too much Inventories – too many funds are tied up in unprofitable assets.
And, there are drawbacks to holding too much cash and liquid assets. Cash could be better spent to generate more sales. Too many debtors increase the likelihood of bad debts. While too much stock increases storage and insurance costs. All these assets should be better placed to increase efficiency, used for growth and expansion.
What does lack of Working Capital mean?
Lack of Working Capital is the single largest cause of business failure. Inadequate Working Capital leads to insolvency. And this can lead to the collapse of the business as creditors will take legal action to recover their money. This causes liquidation of the firm, i.e. it will need to sell off its assets to repay as much of the money owed to its creditors.
When is Current Ratio too low? If Current Ratio is below 1, then the firm has a liquidity problem as its Current Assets are not enough to cover its Current Liabilities. If Current Ratio is below 1, then the short-term debts of the business are greater than its Current Assets. This could jeopardize survival of the business, if all creditors demand payment at the same time. A low ratio might lead to corrective management action to increase cash held by the business.
Hence, it is common for a new business to produce Cash Flow Statement and Cash Flow Forecast in the business plan so that provisions can be taken to cover any shortfalls.
How to improve Working Capital?
A business can improve its Working Capital by reducing inventory levels to keep less stock, negotiating longer credit terms with its suppliers so cash can be kept in the business for longer time or reducing the amount of time it takes to receive payments from customers who have been supplied goods on credit terms.
A permanent increase in Working Capital
With business expansion, businesses will obviously need higher inventory levels. And, as they have more customers, firms will naturally sell a higher value of products on credit. So, the amount of Working Capital will increase with it.
Special situations regarding Working Capital
Under special circumstances, business will have a greater need for finance. This might happen when there is a temporary decline in sales due to economic recession or when a business lost a major customer. In all of those situations, additional finance will be quickly needed to pay for essential expenses.
In conclusions, there is no ‘correct level’ of Working Capital for all businesses.
Requirements for Working Capital will depend on a number of factors, especially the length of the Working Capital Cycle. While too little liquidity can lead to business failure, on another hand, too much liquidity is wasteful.
Managing Working Capital is as much about looking after appropriate amount of cash as it is about the timings of cash received and cash spent. Finally, other features of management are important too – efficient operations management to reduce waste, lowering inventory levels by using Just-in-Time (JIT), speeding up the sale of goods and cash collection period, etc.
