concept and importance of working capital

5.1.1 The Need for Business Finance

Objective

To understand why businesses require finance, the different types of finance needed, the main sources of finance, the factors that influence the choice of finance, and the special role of working‑capital and cash‑flow forecasting in keeping a business running smoothly.

Why Do Businesses Need Finance?

• Start‑up finance – purchase equipment, obtain premises and cover initial operating costs.
• Growth / expansion finance – buy new machinery, open additional outlets or launch new product lines.
• Contingency finance – cope with unexpected events such as equipment breakdowns, market downturns or seasonal cash‑flow gaps.
• Working‑capital finance – meet day‑to‑day operating expenses (stock, wages, utilities, etc.).

Short‑Term vs. Long‑Term Finance Needs

Finance need	Typical time‑frame	Typical use
Short‑term finance	Up to 12 months	Purchasing inventory, paying wages, covering seasonal cash‑flow gaps.
Long‑term finance	More than 12 months	Buying land/buildings, major plant & equipment, research & development.

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5.1.2 Main Sources of Finance

Classification of sources

Sources can be viewed in two dimensions:

• Internal vs. external – whether the finance comes from within the business (e.g., retained profits) or from outside parties (e.g., banks, investors).
• Short‑term vs. long‑term – whether the finance is required for less than 12 months or for a longer period.

Source table (aligned with the syllabus)

Source	Internal / External	Short‑term / Long‑term	Typical example
Retained profits / owner's capital	Internal	Both	Re‑investing profit from the previous year.
Bank overdraft	External	Short‑term	Facility to withdraw up to a pre‑agreed limit.
Trade credit (payables)	External	Short‑term	Suppliers allow 30‑day payment terms.
Bank loan / mortgage	External	Long‑term	5‑year loan to purchase new machinery.
Debentures / bonds	External	Long‑term	Company issues 10‑year bonds to raise capital.
Leasing	External	Long‑term (often 3‑5 years)	Leasing a fleet of delivery vans.
Equity finance (shares)	External	Long‑term	Issuing new ordinary shares to raise cash.
Micro‑finance	External	Short‑term / medium‑term	Small loan to a start‑up retailer.
Crowd‑funding	External	Short‑term	Online platform raising funds for a new product.

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5.1.3 Factors Influencing the Choice of Finance

When deciding which finance to use, businesses should consider the following checklist (mirroring the Cambridge syllabus):

• Size of the business – larger firms may have easier access to capital markets.
• Legal form – sole trader, partnership or limited company affect the type of finance that can be raised.
• Amount required – small cash needs often met with overdrafts; large sums may need long‑term loans.
• Term required – short‑term needs need quick‑turnaround finance; long‑term projects need stable, longer‑term funding.
• Existing debt levels – high existing debt may limit further borrowing.
• Cost of finance – interest rates, fees and any dilution of control.
• Risk and security – secured vs. unsecured finance, and the impact on the business’s risk profile.

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5.1.4 Cash‑Flow Forecasting

Purpose

A cash‑flow forecast shows the expected inflows and outflows over a future period (usually 3–12 months). It helps identify cash shortages before they occur and enables proactive action.

Sample forecast (illustrative)

Month	Cash inflows (£)	Cash outflows (£)	Net cash (£)
January	45,000	40,000	5,000
February	42,000	48,000	-6,000
March	50,000	42,000	8,000
Total	137,000	130,000	7,000

Interpretation: The forecast shows a cash deficit of £6,000 in February. Possible actions:

• Accelerate collection of receivables (e.g., offer a small discount for early payment).
• Delay non‑essential purchases.
• Arrange a short‑term overdraft to cover the shortfall.

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5.1.5 Working Capital – Concept and Importance

5.1.5.1 Definition

Working capital is the amount of money a business has available to meet its day‑to‑day operating expenses. It is the difference between current assets and current liabilities.

Formula:

$$\text{Working Capital} = \text{Current Assets} - \text{Current Liabilities}$$

5.1.5.2 Components of Working Capital

Current assets	Current liabilities
Cash and cash equivalents	Bank overdrafts
Trade receivables (money owed by customers)	Trade payables (money owed to suppliers)
Inventory (raw materials, work‑in‑process, finished goods)	Short‑term loans
Pre‑payments and other short‑term assets	Accrued expenses (wages, taxes, etc.)

5.1.5.3 Why Working Capital Is Needed

• Liquidity – ensures the business can meet short‑term debts when they fall due.
• Operational continuity – provides cash to purchase raw materials, pay wages and cover routine expenses.
• Flexibility – enables the firm to seize unexpected opportunities (bulk‑buy discounts, urgent orders).
• Creditworthiness – a healthy working‑capital position improves relationships with banks and suppliers.
• Risk mitigation – reduces the chance of insolvency caused by cash‑flow gaps.

5.1.5.4 The Cash‑Conversion Cycle (CCC)

The CCC shows how long cash is tied up in the operating cycle:

1. Inventory period – cash spent to buy stock.
2. Receivables period – cash received from customers after sales.
3. Payables period – cash delayed by taking credit from suppliers.

CCC = Inventory days + Receivables days – Payables days

5.1.5.5 Managing Working Capital Effectively

1. Maintain sufficient cash balances to meet immediate obligations.
2. Optimise inventory levels – avoid excess holding costs while preventing stock‑outs.
3. Accelerate collection of receivables through credit control and prompt invoicing.
4. Negotiate favourable payment terms with suppliers to extend payables without damaging relationships.
5. Monitor and shorten the cash‑conversion cycle wherever possible.

5.1.5.6 Example Calculation

Small manufacturing firm (figures in £):

• Cash: 15,000
• Trade receivables: 40,000
• Inventory: 30,000
• Trade payables: 25,000
• Short‑term loan: 10,000

Working Capital = (15,000 + 40,000 + 30,000) – (25,000 + 10,000) = 85,000 – 35,000 = £50,000

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Key Take‑aways

• Businesses need finance for start‑up, growth, contingency and day‑to‑day operations.
• Finance sources are classified as internal/external and short‑term/long‑term; the syllabus expects a clear table that also includes micro‑finance and crowd‑funding.
• Choosing finance depends on size, legal form, amount, term, existing debt, cost and risk.
• Cash‑flow forecasting anticipates shortfalls and supports timely remedial action.
• Working capital (current assets – current liabilities) is the lifeblood of daily activity; a positive figure indicates adequate liquidity.
• Effective working‑capital management balances cash, receivables, inventory and payables, shortens the cash‑conversion cycle, and underpins profitability and risk control.