5.1 Business finance – Working capital
Objective
Understand the meaning and importance of working capital in a business.
What is Working Capital? 💰
Working capital is the short‑term liquidity that a company uses to run its day‑to‑day operations. It is the amount of money that is available to pay suppliers, employees, and other short‑term expenses.
Formula: \$W = CA - CL\$ where CA = Current Assets and CL = Current Liabilities.
\$W = CA - CL\$
| Current Assets | Amount (£) |
|---|
| Cash | 5,000 |
| Accounts Receivable | 10,000 |
| Inventory | 15,000 |
| Total Current Assets | 30,000 |
| Current Liabilities | Amount (£) |
|---|
| Accounts Payable | 8,000 |
| Short‑term Loans | 5,000 |
| Total Current Liabilities | 13,000 |
Working capital = £30,000 – £13,000 = £17,000.
Why is Working Capital Important? 📈
- Ensures liquidity – the business can meet its short‑term obligations.
- Supports operational efficiency – smooth production and sales cycles.
- Reduces the risk of insolvency – prevents cash shortages that could force a company to shut down.
- Helps manage cash flow – balances inflows and outflows.
Calculating Working Capital 🧮
- Identify all current assets (cash, receivables, inventory, etc.).
- Identify all current liabilities (payables, short‑term debt, etc.).
- Subtract liabilities from assets: \$W = CA - CL\$.
- Interpret the result: positive → surplus; negative → shortfall.
Working Capital Ratio (Current Ratio) 📊
The current ratio shows how many pounds of current assets a company has for every pound of current liabilities.
Formula: \$CR = \dfrac{CA}{CL}\$
Example: Using the figures above, \$CR = \dfrac{30,000}{13,000} \approx 2.31\$.
A ratio > 1 indicates good liquidity; < 1 may signal potential problems.
Examples & Analogies 🚗💡
Think of working capital as the fuel in a car. If you run out of fuel, the car stops. Similarly, if a business runs out of working capital, it can’t pay suppliers or keep production going.
Another analogy: your wallet. You need cash to buy groceries, pay bills, and handle emergencies. Working capital is the business’s wallet.
Example: A small café has £5,000 in cash, £3,000 in unpaid customer orders (receivables), and £2,000 in inventory. Its current liabilities are £4,000 in supplier bills and £1,000 in short‑term loan interest. Working capital = (5,000 + 3,000 + 2,000) – (4,000 + 1,000) = £5,000.
Exam Tips for Working Capital Questions 📝
- Always identify current assets and current liabilities before calculating.
- Remember the formula: \$W = CA - CL\$.
- Check the units – usually pounds (£).
- Look for words like “current”, “short‑term”, “cash”, “inventory”, “receivables”, “payables”, “short‑term debt”.
- If the question asks for the working capital ratio, use \$CR = \dfrac{CA}{CL}\$.
- Interpret the sign: positive = surplus, negative = shortfall.
- Use a clear step‑by‑step approach in your answer to show understanding.
Quick Recap 🔄
- Working capital = Current assets – Current liabilities.
- Positive working capital = business can cover short‑term debts.
- Current ratio > 1 = good liquidity.
- Use the formula and check units.
- Think of working capital as the business’s “cash wallet” or “fuel”.
Key Terms 📚
- Current Assets: Assets that can be converted to cash within a year.
- Current Liabilities: Obligations due within a year.
- Working Capital: The difference between current assets and current liabilities.
- Current Ratio: Current assets divided by current liabilities.
- Liquidity: Ability to meet short‑term obligations.