the meaning and importance of working capital

5.1 Business Finance – Working Capital

5.1.1 The Need for Finance

• Short‑term finance – funds the day‑to‑day operating cycle (stock, receivables, payables, cash). It must be repaid within 12 months.
• Long‑term finance – funds capital investment such as plant, property, research & development and is usually repaid over several years.
• Cash vs. profit
  • Profit = total revenue – total expenses for a period (shown on the income statement).
  • Cash = money actually in the bank at a point in time.
  • A business can be profitable but still run out of cash if cash inflows are delayed (high receivables) or cash outflows are accelerated (large stock purchases).
• Business failure – the three outcomes required by the syllabus
  • Bankruptcy – a legal status of an individual or partnership that cannot meet its debt obligations; the court may order the sale of assets to pay creditors.
  • Liquidation – the process of winding up a company, selling its assets and distributing the proceeds to creditors and, if anything remains, to shareholders.
  • Administration – a rescue‑oriented procedure in which an appointed administrator takes control of the company to try to achieve a better outcome for creditors than immediate liquidation.

  Inadequate working capital can trigger any of these outcomes because the business is unable to meet its short‑term liabilities, leading to loss of supplier credit, missed payroll, and ultimately legal action.

5.1.2 Definition of Working Capital

Working capital is the amount of finance a business has available for its day‑to‑day operations. It is the difference between current assets (assets convertible to cash within one year) and current liabilities (obligations due within one year).

Formula:

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

Example calculation (using figures from the “What‑If” scenario below):

Current Assets = £250 000 Current Liabilities = £120 000

Working Capital = £250 000 – £120 000 = £130 000

5.1.3 Working‑Capital Cycle

The working‑capital cycle shows the flow of cash through the operating activities of a business and the time taken at each stage.

1. Cash is used to purchase raw materials / inventory (Inventory days).
2. Inventory is converted into finished goods and sold on credit (Receivables days).
3. Credit sales create trade receivables.
4. Receivables are collected, converting back into cash.
5. During the cycle cash is also required to settle trade payables (Payables days) and other short‑term liabilities.

Cash‑Conversion Cycle (CCC) – worked example

• Inventory days = 60 days
• Receivables days = 30 days
• Payables days = 45 days

$$\text{CCC}= \text{Inventory days} + \text{Receivables days} - \text{Payables days} = 60 + 30 - 45 = \mathbf{45\;days}$$

A shorter CCC means less cash is tied up in the operating cycle and therefore a lower working‑capital requirement.

5.1.4 Sources of Finance for Working Capital

5.1.4.1 Internal Sources

• Retained earnings / undistributed profit.
• Sale of non‑core assets (e.g., surplus equipment).
• Cash generated from operating activities (cash‑flow surplus).

5.1.4.2 External Sources

5.1.4.3 Choosing a Source – Key Factors (Syllabus 5.1.6)

• Cost of finance – interest rate, arrangement fees, discount fees.
• Security requirements – impact on asset ownership and risk.
• Flexibility – ability to draw, repay, and vary the amount as cash flow fluctuates.
• Speed of approval – how quickly the funds become available.
• Effect on profitability and ratios – e.g., current ratio, interest‑coverage.
• Relationship considerations – maintaining good supplier or bank relationships.

5.1.5 Managing Working Capital Effectively

5.1.5.1 Main Components of Working Capital

1. Cash and cash equivalents
2. Trade receivables
3. Inventory (raw materials, work‑in‑process, finished goods)
4. Pre‑payments and other short‑term assets
5. Trade payables
6. Short‑term borrowings and other current liabilities

5.1.5.2 Working‑Capital Ratios (Syllabus Requirement 5.1.6)

5.1.5.3 Practical Techniques

1. Cash Management
   • Prepare a cash budget (see 5.3) to forecast inflows and outflows.
   • Accelerate inflows – offer early‑payment discounts, use electronic invoicing.
   • Delay non‑essential outflows – negotiate staggered payments, use sweep accounts.
2. Receivables Management
   • Set clear credit policies (credit limits, payment terms).
   • Carry out credit checks before extending credit.
   • Issue invoices promptly and follow up with reminders.
   • Consider factoring for high‑risk or slow‑paying customers.
3. Inventory Management
   • Adopt Just‑In‑Time (JIT) or Kanban systems to reduce holding costs.
   • Calculate Economic Order Quantity (EOQ) to balance ordering and holding costs.
   • Perform regular stock reviews and ABC analysis.
4. Payables Management
   • Negotiate favourable credit terms with suppliers.
   • Take the full credit period without damaging relationships.
   • Use early‑payment discounts only when the discount rate exceeds the cost of borrowing.
5. Financing Options (see 5.1.4)
   • Match the timing of cash‑flow gaps with the cheapest, most flexible source.
   • Assess the impact on profitability (interest expense) and on liquidity ratios.

5.1.5.4 What‑If Scenario – Impact of a Change in Inventory

Assume the business increases its inventory by £20 000 (a 16.7 % rise).

• Working capital rises by £20 000, tying up cash in inventory.
• If the extra stock does not generate additional sales quickly, the cash‑flow forecast will show a shortfall, possibly requiring short‑term borrowing.
• Current ratio improves (250 000 / 120 000 = 2.08) but underlying liquidity may be poorer because cash is immobilised in stock.

5.1.6 Links to Other Syllabus Areas

• Cash‑flow forecasting (5.3) – Working‑capital forecasts form the core of the cash‑flow schedule; any change in receivables, inventory or payables must be reflected.
• Cost information (5.4) – Holding inventory incurs carrying costs (storage, insurance, obsolescence). Reducing inventory through JIT lowers these costs and improves profitability.
• Ethical and CSR considerations
  • Fair credit terms for small suppliers support sustainable supply chains.
  • Aggressive collection practices can breach customer rights – a responsible firm uses proportionate reminders.
  • Maintaining adequate cash reserves safeguards employee wages, health‑and‑safety investments and community commitments.

5.1.7 Summary Checklist

• Explain why finance is needed (short‑ vs long‑term) and give the definition of working capital.
• Distinguish between cash and profit and describe how a lack of cash can lead to bankruptcy, liquidation or administration.
• Identify internal and external sources of finance for working capital and the factors influencing the choice of source.
• Draw and label the working‑capital cycle, and calculate the cash‑conversion cycle in days.
• Compute and interpret the current ratio, quick ratio and cash‑conversion cycle.
• Apply techniques to improve cash flow, manage receivables, control inventory and negotiate payables.
• Link working‑capital management to cash‑flow forecasting and cost information.
• Consider ethical/CSR implications of working‑capital decisions.