Working Capital is a measure of the capital required to cover the day-to-day operations of your business. It indicates your ability to meet short-term obligations as they fall due.
If your current assets do not exceed your current liabilities, you may have difficulty paying back creditors in the short term.
Working capital provides you with the level of available resources to pay bills as they arise. A negative working capital result will indicate that you may have trouble paying debts, and are at risk of bankruptcy.
Investors use working capital to analyse the operational efficiency of your business. If funds are tied up in inventory or credit customers, they cannot be used to pay off your obligations as they fall due. If you’re not operating in the most efficient manner, it will be evident in a high working capital level and highlight your inability to utilise cash effectively for growth.
Comparing the working capital from one period to another can help identify any underlying problem in our company’s operations such as slow payment from customers or a decline in sales.
Working Capital = current assets – current liabilities.
For example, if our balance sheet at the 31 December reported a total current assets figure of $235,000 and a total current liabilities figure of $220,000 then our working capital at the 31 December would be $15,000.
Current Assets (receivable within 1 year) can include:
- Inventory (Stock)
- Trade Receivables (Credit customers/debtors)
- Cash (and marketable securities)
Current Liabilities (payable within 1 year) can include:
- Trade Payables (Creditor customers/creditors)
- Short-term borrowings
The Current Ratio and Acid Test Ratio are commonly used to analyse Working Capital.
1) Current Ratio
Current Assets : Current Liabilities
The current ratio indicates the extent to which your current assets cover your current liabilities. The optimum level is considered to be 2:1, however, each industry is different. When calculating this ratio for your business use your industry norm as a benchmark for comparison.
A current ratio of less than 2:1 could signal liquidity issues. A ratio of greater than 2:1 could indicate that you haven’t efficiently managed your working capital.
A ratio of 1 would indicate that your current assets equal your current liabilities. This would be considered the middle ground as it is not extremely risky nor is it completely safe. A ratio of 1 means that you would have to sell all of your current assets to pay your current liabilities.
2 – Acid Test ratio
(Current Assets – Inventory) : Current Liabilities
In the acid test ratio, we remove inventory from the analysis. We do so because it is the least liquid of the current assets, meaning that it is the slowest to convert into cash.
The acid test ratio indicates your ability to respond quickly to liquidity needs. The benchmark is considered to be 1:1 but again, your particular industry average should be used as a benchmark.
Working capital involves determining the level of inventory to keep in your warehouse, the credit period you should offer your customers and what credit period you should take from your suppliers. It also involves establishing the amount of cash that you need to keep on hand.
A fundamental part of your success will lay in your ability to efficiently carry on operations while effectively minimising your costs. While amounts tied up in working capital represent a cost, they are necessary for normal trading activities and to generate a profit.
Components of working capital are expected to be realised within a short period of time and are required on an on-going basis. They are turned over many times during the year and as a result, your working capital will require a permanent investment.
Achieving success in your business will involve effectively establishing the optimal balance of these components and ensuring a sufficient level of working capital is available to avoid negatively impacting on our company’s operations. Maintaining an adequate level of liquidity while ensuring that the costs associated with working capital are minimised will play a fundamental role in the successful management of your working capital.
Components of Working Capital
Stock levels must be sufficient so sales orders can be satisfied and lost sales prevented. Avoiding stock outs is of paramount importance, as the consequences can be quite high depending on your business and economic state.
While ensuring that you have an appropriate level of stock available, you must avoid maintaining too high of inventory levels as this will increase stock holding costs.
Increasing inventories may indicate a slow turnover of inventory and an inefficient use of cash as funds tied up in inventory could be used in other profit generating activities.
If a large proportion of your current assets are inventory then you will require a greater amount of working capital. Stock is the least liquid out of all the current assets, therefore, takes longer to convert to cash.
The faster the assets can be converted into cash, the more likely you will have the cash in time to pay our debts.
2) Credit Customers
The credit period you offer customers should be sufficient so they do not leave for your competitors while exceeding the costs associated with offering that credit period.
Remaining competitive and avoiding lost sales means considering credit policies offered by competitors and the needs of customers. In addition, you must take into account the increased risk of bad debts, additional administration work required in chasing up these debts and the cost of funds tied up in this way.
Decreasing trade receivable turnover may indicate that more of your customers are not paying amounts due on time, which reduces our ability to pay debts as they fall due.
3) Trade payables
When suppliers provide a credit period they are effectively giving you an interest-free loan. By extending this period you are essentially extending your loan period, thereby retaining the funds in your business longer which can be used in other profit generating activities.
However, delaying payment till after the due period is likely to incur additional costs such as interest and loss of discounts.
Maintaining a sufficient cash level is essential to meet payments such as wages as they fall due, while too high a level or increasing cash balances may indicate that you have not utilised cash effectively for growth.
For example, extra cash that we have sitting in our bank current account is not earning any return whereas if you invested surplus cash you could earn interest.
It is essential to identify the optimum levels of each component of working capital while maintaining a healthy balance between liquidity and profitability. Managing working capital efficiently and effectively will be crucial to the success of your business.
It is particularly important for small companies who do not have the ability to access the financial markets for funding, and for start-ups that need to survive until they break even.
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- Cash Flow Analysis and Forecasting: The Definitive Guide to Understanding and Using Published Cash Flow Data 1st Edition – by
- Working Capital Management: Applications and Case Studies (Wiley Corporate F&A) – by
- Finance: Theory and Practice (3rd Edition) – by Anne Marie Ward
- Financial Management for Decision Makers: (7th Edition) – by Peter Atrill
- Managing Cash Flow: An Operational Focus – by