Everybody is familiar with the concept of having enough money in their bank to
pay the bills at the end of the month.
Working capital works on much the same principle.
The process of financial managementi.e. Measuring and controlling your level of
working capital, ensures your business can function from day to day and
have enough current assets (money) to pay your current liabilities (bills).
How is working capital calculated?
Current Assets – Current Liabilities = Working Capital
This is also sometimes called “Net Working Capital”.
The figure can be positive, negative, or zero.
Generally, a positive figure is seen as good. If the current assets exactly equal
the liabilities the business has no reserves to meet unexpected events like repairs,
stock problems, staff recruitment, etc, etc.
Current assets include anything that is able to be converted into
money within 12 months
Some examples of current assets are:
- Cash or its equivalent – (overdrafts and credit cards fall under this heading)
- Inventory / Stock / WIP – Most businesses expect their stock to sell within 12 months
- Debtors – This is anybody who owes the business money, usually having purchased something on credit
These are the exact opposites of current assets. They include anything that has to
be paid within 12 months and represent claims made against the business.
Some examples include:
- Rents / Mortgages
- Utility bills
- Bank Interest on loans
The Importance of working capital
A business may be profitable but is at risk of failing if the working capital is not
Many new businesses often fail due to working capital problems.
Working Capital can be seen as the lifeblood of business,
the oil that keeps the machine running.
The options open to businesses for increasing the level of working capital include:
Obtaining / increasing an overdraft
This is one of the most common methods of improving working capital and
the least costly. Most banks offer competitive overdraft rates and
overdrafts are quick to set up and easy to manage.
A bank may well agree to a short-term loan (of less than one year duration) to
provide temporary financing.
Note that the interest on the loan will become a new current liability.
Factoring is a type of lending where an external company will advance the
business money against the value of the outstanding invoices.
The factoring company charges a service fee and interest on the value of
the outstanding invoices.
Factoring typically appeals to small businesses. An “in-house” solution is to reduce
the time it takes customers who owe the business money (debtors) to settle their account.
Both methods improve working capital.
Working capital is improved by lengthening the time creditors are paid.
Rather than paying trade creditor invoices immediately,
a business can improve working capital by waiting until they actually fall due.
Also, it might be possible to renegotiate credit terms, such as moving from 30 days to
60 days for repayment, or to a “sale or return” policy.
For many small businesses, equity is a popular way of improving working capital.
Entrepreneurs may invest their own funds, or those of family members or
friends into the business. Some companies (like internet-start-ups in particular)
will use venture capital funds. Once a business is established, a share- issue or
reducing the share dividend are two common methods of improving working capital.