By adding together the totals for current assets and current liabilities in the balance sheet, a very important figure can be calculated – working capital.
Working capital = current assets less current liabilities
Working capital provides a strong indication of a business' ability to pay is debts.
Every business needs to be able to maintain day-to-day cash flow. It needs enough to pay staff wages when they fall due, and to pay suppliers when invoice payment terms are reached. Maintaining adequate working capital is important both in the short-term (day-to-day) and the long-term. The challenge is to maintain sufficient liquidity in the business to ensure the business can survive and grow in the long-term.
The current liabilities show the amounts that need to be paid in the next twelve months. Current assets show the cash and other assets that are available to settle those current liabilities.
Of course the balance sheet is just a snapshot of the working capital position at a point in time (the balance sheet date). In reality, a business is constantly settling liabilities, taking money from customers, buying inventories and so on. This is known as the working capital cycle, (sometimes also known as the operating cycle) as illustrated below:
In the diagram above:
The working capital cycle can often be expressed as a period of time – 60 days, say.
An increase in the length of the cycle (e.g. from 60 days to 65 days) suggests that it takes longer to turn stocks and debtors into cash, or that the payment period for settling creditors has shortened.
Hopefully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But not necessarily, and if management don't carefully monitor cash flow and take corrective action when necessary, a business may find itself sinking into trouble. The cash needed to make the cycle above work effectively is working capital.
What is crucially important is that a business actively manages working capital. It is the timing of cash flows which can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not necessarily mean that there is cash coming into and out of the business.
Factors affecting the level of working capital
It is important to remember that different industries have different working capital profiles, reflecting their methods of doing business and what they are selling. For example:
Working capital needs also fluctuate during the year
The amount of funds tied up in working capital would not typically be a constant figure throughout the year. Only in the most unusual of businesses would there be a constant need for working capital funding. For most businesses there would be weekly fluctuations.
Many businesses operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others.
The amount of working capital held by a business depends on a variety of factors: for example:
Need to hold inventories
Some businesses need to hold substantial inventories to meet customer needs – e.g. retailers and distributors
Production lead time
A product that is made and sold within a short time (e.g. fresh food) requires much less inventory than one where the production process takes a long time (e.g. production of mature cheese!)
Businesses that successfully implement lean production techniques find that they need to hold significantly less inventory
Expected credit period by customers
In some industries it is expected that a long credit period can be taken before trade debtors need to settle their invoices – which means that higher working capital is required
Effectiveness of the credit control function
A poorly managed credit control department will allow customers to take too much credit and take too long to settle their bills – which will mean higher trade debtors and higher working capital
Credit period offered by suppliers
The longer the credit offered by suppliers, the better for cash flow and working capital.
Main causes of working capital problems
It follows from the above that the main causes of working capital (and therefore cash flow) problems are:
Fully worked A Grade answers to recent Edexcel GCSE Business Studies Unit 3 exam papers with detailed examiner commentary on how good technique scores top marks