Any business needs a working capital to fund the day-to-day operations, which include debts and expenses, and forms a major component of the operating liquidity. Apart from the fixed assets such as plant and machinery, equipment, land etc. the working capital also is an integral part of the operating capital.
We can understand the concept of working capital by understanding the terms working capital gap and short-term borrowings. Companies define current assets and current liabilities in their balance sheets with respect to the assets and liabilities that are expected to be realized or settled within the normal operating cycle (i.e. 12 months after the balance sheet date). This is where the concept of working capital arises from. If you’re new to these terms, you may first want to take this introductory course on business finance before moving ahead.
What is Working Capital?
Working capital denotes the aggregate value of the current assets of a company, which can be continuously circulated to support the current operations. The working capital further helps us in understanding the liquidity position of an organization, i.e. how fast can the assets be converted into cash.
If the current asset value is more than the current liabilities, then the company has a ‘positive working capital’, whereas if it is the other way around, then the company is said to have a working capital deficit. The positive working capital of a business ensures that the company has enough funds to support its operating expenses and short-term debts. Learn more about importance of working capital in our course on financial accounting for business managers.
We can now define the working capital as follows:
- Working capital gap = (aggregate of current assets – interest free credit)
- Net Working Capital (NWC) = (working capital gap – short-term borrowings)
The aggregate of current assets is known as Gross Working Capital. For example, say the current assets of company XYZ are $10,000,000 and the interest free credit is $2,000,000 and short-term borrowing is $5,000,000. Then we shall calculate the net working capital as follows:
Gross working capital = $10,000,000
Working capital gap = $ (10,000,000 – 2,000,000) = $8,000,000
Net working capital = $(8,000,000 – 5,000,000) = $3,000,000
Understanding Working Capital Cycle
The working capital cycle is the time duration between paying for raw materials and goods that were bought to manufacture products and the final receipt of cash that you earn on selling the products. So basically, it denotes the time required by your business operations to convert the current assets and current liabilities into cash. The shorter the working capital cycle, the more effective is your working capital. If the working capital cycle is too long, then your capital gets tied up in the operational cycle without earning returns. Therefore, companies try to achieve shorter working capital cycles to increase their business efficiencies.
If you are the owner of a small business or aspire to be an entrepreneur, then you must understand the importance of the working capital cycle and cash flow management. Skip right ahead to our introductory course on business finance, which will help you do so.
The working capital cycle comprises of four parts – cash, creditors, inventory and debtors. For a successful cash-flow management, you need to have complete control on each of these aspects of the working capital cycle. The shorter your working capital cycle, the faster you can convert inventory into cash thereby lessening your dependency for cash on customer payments and loans.
The following example will give you a better understanding on the importance of having a shorter working capital cycle:
Let’s say that the company XYZ has to pay its suppliers in 30 days but collects its receivables from customers in 60 days; therefore having a working capital cycle of 30 days. In these 30 days, the company has to meet the day-to-day operational expenses by means of short-term borrowings, which attract certain interests. This leads to extra costs thereby reducing the company’s profits.
Had the working capital cycle been shorter, the company would have free cash to support the expenses and not have to depend on loans. The amount of cash-flow available in a business indicates its efficiency in managing the balance sheet and generating free cash. Smaller businesses face relatively higher costs to raise funds on short notice; therefore it’s important for them to hold large reserves of cash. Businesses often suffer due to mismanagement of cash-flow and end up having huge debts, which further decreases their profitability. It’s very important for business managers and financial executives to concentrate on short-term financial planning of an organization to take care of future cash balances. For an in-depth knowledge on cash budgeting and financial planning, visit our course on financial modelling for small businesses.
If you are a business manager or looking to venture as an entrepreneur, it’s imperative for you to know about working capital management and its relevance in achieving business efficiency. You first need to understand the industry in which you operate or about to operate in and find out how much working capital you will need. It is not only about managing cash-flow for operations but also keeping enough reserves to meet maturing short-term debts and upcoming expenses. You also need to keep in mind that the financial decisions you take with respect to capital investment opportunities and short-term financing strategies can affect your working capital and cash balances.
What’s the Optimum Level of Working Capital?
If the working capital is too high, then your business has surplus funds that are not earning any returns, unless they are invested in short-term securities etc. If the working capital is too low, then your business faces the threat of financial difficulties and this will not send out a positive signal to the market. So how do you decide what is the right level of working capital for your business? For this, you need to know more about your business environment.
Let’s say you are operating a business in the software domain catering to the services industry; then the levels of working capital required will be less than that required by a manufacturing firm for example. The reason for this is that the inventory levels are less and the time required to deliver the service and generate cash will also be lesser than that required to produce and sell goods.
To find out the right amount of working capital needed, you need to look at your recent balance sheet and take into the account the current assets and current liabilities for calculations. Once you have found the working capital required, you also need to know whether the safety margin is wide enough to operate efficiently. For this, you need to calculate the ‘working capital ratio’.
Working capital ratio (or current ratio) = current assets / current liabilities
The current ratio is one of the liquidity ratios that helps you measure the capability of your business to meet short term financial commitments as and when they become due. Higher the current ratio better is the capacity to meet short term financial obligations. In other words, it means that your business has enough current assets to pay off your current liabilities.
If you look at the software giant Microsoft’s pay-out bonanza in the year 2004, you will understand that having too much cash surplus is also a difficult situation to manage. The company had long been generating cash at the rate of $1 billion every month and then to everyone’s surprise, on 20th July 2004, it announced that it would give back $75 billion to the shareholders in different forms. First, it paid $32 billion as a one-time dividend, then took the decision to buy-back shares worth $30 billion over four years’ time and as the third step, it decided to double its dividend to 32 cents per share annually, payable in quarterly instalments. This decision by Microsoft attracted a lot of speculation in the market as to whether the company’s growth had stalled? However, it proved to be the smartest business decision in terms of not only giving back to the investors but also earning the trust and respect of the shareholders! (Source: http://www.economist.com/node/2949080)
Approach to Managing the Working Capital Cycle
Decisions on working capital management are taken based on several criteria, some of which are explained below:
- Cash-conversion cycle – It’s important to measure the cash flow and one method to do so is to find out the number of days between spending money on raw materials and receiving cash from the customer. This helps you understand the relationship between inventories, accounts payable and receivable, and cash. It helps you find out the amount of cash tied up in ongoing operations, which is not available for other activities.
- Return on capital (ROC) – This is a measure of profitability and is an indication of the company’s value to its shareholders. If the ROC of a firm is more than the cost of capital, then its value is enhanced; it is an efficient management tool that helps business managers in linking short-term policies with long-term decision making.
- Credit policy – A very important factor that affects the cash-conversion cycle and the working capital management thereby, is the credit policy of a company. It specifies whether the company buys material and sells products and services in cash or on credit.
There are several techniques that can be adopted by companies to manage the working capital such as:
- Cash management – one needs to identify the cash balance available to meet the day to day expenses, taking care that cash holding costs care not increased
- Inventory management – Managing inventories so as to allow for a smooth production while keeping your investments in raw materials low is another way to manage the working capital. Learn more about JIT and economic order quantity in our course on supply chain management for business efficiency. Learn more on inventory management with this financial accounting course.
- Debtor’s management – This involves taking decisions on the credit policy of our company, managing discounts and allowances etc.
- Short-term financing – Depending on your cash-conversion cycle, you may opt for short-term financing to meet your inventory and operational expenses, without too much implication on our working capital
If you are aspiring to be an entrepreneur or managing a small or medium sized business, you should know the basics of working capital management and how to calculate the working capital for your business. In short, managing the working capital cycle of your business is crucial to its long-term growth and success.