All businesses need finance to pay for everyday expenses such as wages and the purchase of stock as well as other financial obligations. Working capital is often described as the ‘lifeblood’ of a business. Working Capital is the difference between a company’s current assets and its current liabilities. It is also known as the net current assets.
Why is working capital important?
It measures a company’s liquidity, it’s operational efficiency and its short-term financial health. A positive working capital shows that a company can meet its short-term financial obligations and be able to invest in future growth activities.
Without sufficient working capital, a business will lack liquidity, thus, it will be unable to pay its immediate or short-term debts or financial obligations. Such business will either raise finance through a bank loan, overdraft, or it may be forced into liquidation by its creditors – the firms it owes money to.
A company whose current liabilities is more than its current assets may have trouble growing or paying back creditors, or may even go bankrupt. A company with negative working capital will have a current ratio of less than one.
Current assets and Current liabilities
Working capital is calculated by subtracting a business’s current liabilities from its current assets (current assets − current liabilities).
Current assets include cash (at hand and in the bank), stocks (inventories), and debtors (accounts receivable). Virtually no business could survive without these three assets, although some businesses will not have debtors because the owners refuse to sell any products on credit. However, this is very rare for businesses beyond a certain size.
On the other hand, current liabilities include accounts payable, wages, taxes, short-term debt payments, including overdrafts, or the current portion of deferred revenues.
Having sufficient working capital
Having sufficient working capital is essential to prevent a business from becoming illiquid and unable to pay its debts. However, working capital can be a disadvantage if it is too high: the opportunity cost of too much capital tied up in stocks, debtors and idle cash is the return that money could earn elsewhere in the business such as if it was invested in fixed assets.
The working capital requirement for any business will depend upon the ‘working capital cycle’. This is the period of time between spending cash on the production process and receiving cash payments from customers.
The longer working capital cycle of a business, the greater the working capital needs of the business will be.
Working capital management
Proper management of a business’ working capital is essential to the fundamental financial health and operational success as a business. A business needs to employ good working capital management to maintain a solid balance between growth, profitability and liquidity.
Credit given to customers by the business will increase the time before a sale is turned into cash thus extending the working capital cycle. Credit received by the business from suppliers will reduce the length of this cycle.
A business will put a strain on its working capital if it gives more credit to customers than it receives from suppliers, there the business will have a need for increased working capital, whereas a business that receives more credit than it gives to its customers will have a reduced need for working capital.
How to improve working capital
A company can improve its working capital in several ways, these include:
- Converting current assets like inventories and accounts receivable to cash in a short period.
- Negotiate better credit terms with suppliers
- Reducing its debtor days ratio – that is the average length of time it takes the business to recover payment from customers who have bought goods on credit. The shorter this time period is, the better the management is at managing debtors and controlling its working capital.
- Earning additional profit by implementing reasonable cost control measures.
- Issuing common stock or preferred stock for cash
- Borrowing money on a long-term basis or replacing short-term debt with long-term debt
- Liquidating long term assets for cash.
Most businesses will try to improve working capital through overdrafts and creditors, however, it would be unwise to obtain all the funds needed from these sources.
First, they may have to be repaid at very short notice, thus 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 which will improve customer satisfaction and retainership.
Ifunanya Ikueze is an Engineer, Safety Professional, Writer, Investor, Entrepreneur and Educator.