Guide to Working Capital: What is Working Capital?

Guide to Working Capital: What is Working Capital?
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Definition of Working Capital

The question of what is working capital can be answered by reference to the funds required by the enterprise for running its day to day operations. The working capital is used to finance the purchase of raw materials and expenses of production, the storage of goods awaiting sale and the expenses of sale, including collection of trade debts from customers.

The working capital held by a business at any particular time is represented by the inventory, accounts receivable (trade debtors), cash and accounts payable (trade creditors). In order to continue as a going concern, the business needs to finance its expenses as they become due, so it is important to keep the working capital circulating as quickly and profitably as possible so as to generate the cash required for business operations and therefore maintain liquidity at a safe level.

If working capital is tied up in unnecessarily high inventories and in trade debtors who are slow to pay, the enterprise cannot free up cash to grow its business and may experience liquidity problems. Where the enterprise can manage its working capital properly, it can reduce the amount that needs to be borrowed to finance its operations.

Working Capital Cycle

The working capital cycle represents the period of time from the purchase of materials on credit for production, through the manufacturing process and paying the wages and overheads, to the storage of goods in a warehouse while they are waiting to be sold. The working capital cycle continues with the sale and delivery of the finished goods on credit and the collection of funds from the resulting trade debtors. Cash collected from debtors can be used in the next cycle to pay the trade creditors resulting from the purchase of further raw materials on credit.

Some of the funds generated from the working capital cycle will be used for other purposes outside the cycle, such as the purchase of fixed assets, payment of dividends to shareholders, repayments to loan creditors or taxation.

Each time that the working capital cycle is completed the enterprise aims to generate profits and have more cash at its disposal to expand the business. Where the business is making a profit it makes sense to reduce the time period of the working capital cycle as much as possible, so as to generate more profits and have more cash available to meet liabilities.

What is Working Capital Management?

A report by the consultants Deloitte in January 2011 suggested that the largest UK companies had £60 billion in working capital tied up for unproductive purposes, owing to poor inventory management and insufficient attention to the top issues pertaining to supply chain management. Strategies to improve the working capital cycle, reducing inventories and introducing more efficient collection of debtors, could streamline business operations and ensure that funds are not locked up unnecessarily.

The way in which working capital management can be put into effect depends on the type of business activity in which the enterprise is engaged. For example, businesses receiving cash directly from customers, such as many retail outlets, would not have a problem with collecting accounts receivable although their cash management would be an important aspect of their working capital management.

Inventory management is a very important aspect of a retail business, with opportunities for efficient working capital management by means of more streamlined purchasing and inventory management systems that can reduce the necessity to carry large volumes of stock. Negotiation of favorable payment terms with creditors is also an important part of working capital management.

In the case of enterprises that are purchasing raw materials for processing into a finished product, working capital is inevitably tied up for longer periods as there are large amounts of expenditure involved in a longer time period between the commencement of the working capital cycle and the time when the inventory of finished goods is sold and the cash is collected from debtors. Good supply chain management is an essential requisite for manufacturers who do not want to see funds tied up in underperforming working capital.

Working Capital Ratio

The working capital ratio, otherwise known as the liquidity ratio (or current ratio), is a guide to how far the enterprise has current assets to meet the short-term liabilities as they become due. The working capital ratio is measured by dividing current assets by current liabilities. The current assets consist of inventory, accounts receivable (trade debtors) and cash, while current liabilities are the trade creditors and other short-term liabilities.

The significance of the resulting figure depends on the type of business in which the company is engaged, and a comparison of an enterprise’s current ratio with the ratios of its competitors in the same industry can be useful. A very rough guide to a suitable level of the current ratio is sometimes estimated to be a figure above 1.2; however the adequacy of this figure depends on how quickly the inventory could be turned into cash to finance debts becoming due in the short term. Where inventory is slow moving and liable to quick obsolescence a better ratio to use might be the quick ratio which excludes inventory from the calculation and divides current assets less inventory by current liabilities.

For many small and start-up businesses, generating enough funds to meet short-term liabilities as they become due is very challenging and many potentially profitable start-up enterprises fail because they do not achieve the required cash flow and short term bills remain unpaid.

Other Ratios

Liquid funds

The working capital ratio isn’t the only method you can use; other accounting ratios that may indicate how well working capital is managed include the Days-Sales Outstanding (DSO) which gives an approximate idea of the number of days the enterprise needs in order to collect payment from trade debtors. The DSO is calculated by dividing accounts receivable by annual sales, and dividing the result by 365. If the DSO is too high, the enterprise is taking too long to collect its debts, converting its accounts receivable into cash, and could therefore face liquidity problems.

Another useful ratio is the inventory turnover ratio, which is measured by dividing the cost of goods sold by the inventory and shows the rate at which the enterprise can sell the goods manufactured or purchased for resale. Goods that are stored in a warehouse awaiting sale are not productive and they take up expensive storage space, so a high inventory turnover ratio is a healthy sign for a business. The enterprise may also find it useful to compare its own inventory turnover ratio with those of its competitors in the same industry, as they are dealing in the same types of goods and a comparison will give a meaningful result.

By paying closer attention to the management of inventory and the prompt collection of trade debtors, together with the negotiation of favorable payment terms with trade creditors and streamlining of the supply chain, enterprises can improve their liquidity and make more efficient use of their working capital. The result can be the release of funds to enable more rapid growth of the business.

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