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Definition

Working capital, also known as net working capital, is a measurement of a businesss currentassets, after subtracting its short-term liabilities, typically short term. Sometimes referred to as

operating capital, it is a valuation of the assets that a business or organization has available to

manage and build the business. Generally speaking, companies with higher amounts of workingcapital are better positioned for success because they have the liquid assets that are essential toexpand their business operations when required.

Working capital refers to the cash that a business requires for its day-to-day operationsforexample, to finance the conversion of raw materials into finished goods that the company can

then sell for payment.

Among the most important items of working capital are levels of inventory, accounts receivable,and accounts payable. Working capital can be expressed as a positive or a negative number.

When a company has more debts than current assets, it has negative working capital. When

current assets outweigh debts, a company has positive working capital.

The requirement for working capital depends on the type of company. Some companies are

intrinsically better off than others. Examples include retailers (which have a fast turnover ofcash) and insurance companies (which receive premiums before having to settle claims).

Manufacturing companies, on the other hand, can incur considerable upfront costs for materialsand labor before they receive payment. For much of the time, these companies spend more cash

than they generate.

A company will try to manage cash by:

y identifying the cash balance that allows it to meet day-to-day expenses but minimizes thecost of holding cash;

y finding the level of inventory that allows for continuous production but lessens theinvestment in raw materials and reduces reordering costs;

y identifying the appropriate source of financing, given the cash-conversion cycle.It may be necessary to use a bank loan or overdraft. However, inventory is preferably financed

by credit arranged with the supplier.

If a company is not operating efficiently, this will show up as an increase in the working capital.

This can be judged by comparing the amounts of working capital from one period to another.Slow collection and inventory turnover may signal an underlying problem in the companysoperations.

Advantages

8/9/2019 Intro to Working Capital Management

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Proper management of working capital gives a firm the assurance that it is able to continue itsoperations and that it has sufficient cash flow to satisfy both maturing short-term debt and

upcoming operational expenses.

Disadvantages

y If a companys current assets do not exceed its current liabilities, then it may run intotrouble paying back creditors in the short term.

y A declining working-capital ratio over a longer time period could also be a red flag thatmerits further analysis. For example, it could be that the companys sales volumes aredecreasing and, as a result, its accounts receivable are diminishing.

Action Checklist

y Check the amount of working capital. If a company is not operating in the most efficientmanner (for example slow collection), it will show up as an increase in working capital.

This can be understood by comparing the working capital from one period to another.Slow collection may signal a fundamental problem in the companys management.

y Is your performance indicator for credit control better than those of other businesses inthe same sector?

y Invoices should always be accurate in every detail and to the penny when quotingamounts. Inaccuracy is an excuse to query and delay payment. Also aim to send out your

invoice the day after delivery of the goods.y Chase debtorsMoney that customers still owe cannot be used meet other obligations.

Dos and Donts

Do

y Check that a company has sufficient working capital, as this is an indicator of the successof the business. Lack of working capital may not only mean that a company is unable togrow, but also that it has too little cash to meet its short-term obligations.

Dont

y Dont allow working capital to fall below the level at which the company has more debtsthan current assets.