The importance of working capital
Many organisations that are profitable on paper are forced to cease trading due to an inabilty to meet short-term debts when they fall due. In order to remain in business it is essential that an organisation successfully manages its working capital. Too often however, this is an area which is ignored. This article will look at the items which comprise working capital, and using live examples will consider the level of working capital required by businesses operating in different industries. We will also look at the problems faced by small businesses before reviewing some of the ways in which an organisation can improve its management of working capital.
1. What is working capital?
The definition of working capital is fairly simple, it is the difference between an organisation's current assets and its current liabilities. Of more importance is its function which is primarily to support the day-to-day financial operations of an organisation, including the purchase of stock, the payment of salaries, wages and other business expenses, and the financing of credit sales.
As the cycle indicates, working capital comprises a number of different items and its management is difficult since these are often linked. Hence altering one item may impact adversely upon other areas of the business. For example, a reduction in the level of stock will see a fall in storage costs and reduce the danger of goods becoming obsolete. It will also reduce the level of resources that an organisation has tied up in stock. However, such an action may damage an organisation's relationship with its customers as they are forced to wait for new stock to be delivered, or worse still may result in lost sales as customers go elsewhere.
Extending the credit period might attract new customers and lead to an increase in turnover. However, in order to finance this new credit facility an organisation might require a bank overdraft. This might result in the profit arising from additional sales actually being less than the cost of the overdraft.
Management must ensure that a business has sufficient working capital. Too little will result in cash flow problems highlighted by an organisation exceeding its agreed overdraft limit, failing to pay suppliers on time, and being unable to claim discounts for prompt payment. In the long run, a business with insufficient working capital will be unable to meet its current obligations and will be forced to cease trading even if it remains profitable on paper.
On the other hand, if an organisation ties up too much of its resources in working capital it will earn a lower than expected rate of return on capital employed. Again this is not a desirable situation.
2. The working capital cycle
The working capital cycle starts when stock is purchased on credit from suppliers and is sold for cash and credit. When cash is received from debtors it is used to pay suppliers, wages and any other expenses. In general a business will want to minimise the length of its working capital cycle thereby reducing its exposure to liquidity problems. Obviously, the longer that a business holds its stock, and the longer it takes for cash to be collected from credit sales, the greater cash flow difficulties an organisation will face.
In managing its working capital a business must therefore consider the following question. 'If goods are received into stock today, on average how long does it take before those goods are sold and the cash received and profit realised from that sale?' The answer will depend upon a number of factors that we will consider later in this article. For now we will turn our attention to calculating the length of a business's working capital cycle.
Dublin Ltd has provided the following information based upon the year to 31 January 1999.
| Credit sales | £1,200,000 |
| Credit purchases | £650,000 |
| Average stock | £80,000 |
| Average debtors | £200,000 |
| Average creditors | £54,000 |
With the help of a few simple ratios we can calculate the length of Dublin's working capital cycle as follows:
We can use the stock days ratio to calculate the average length of time that goods remain in stock:
| Average stock | *365 days = | 80,000*365 | = 45 days |
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