Friday, 16 December 2016

Understanding Working Capital

  1. The above figure shows a typical working capital cycle. 
  2. Cash is used to purchase raw materials . 
  3. The raw materials are then turned into finished goods and sold to customers, usually for a credit period. 
  4. Ultimately payment is received in cash from the customer and the cycle repeats. 

Sometimes working Capital can turn negative but before jumping to conclusion about it let us discuss it in length.

What Does Negative Working Capital Mean?

Now the first conclusion about negative working capital would be low efficiency and fact that an entity needs external funding even for day to day operations. 
But having excess of short term liabilities over short-term assets is not always unfavourable. 
  • A sudden surge in creditors or dip in debtors can be result of one-off bulk payments and adjustments that make working capital negative but for a short period of time.  
A negative working capital which sustains over extended period is definitely a cause of concern.
  • It could be because the finished product is being sold at very low margins or loss. This strategy is sometimes followed by companies who are looking at either increasing their market share or introducing new products. 
  • Another instance is sizeble bad debts where debtors have gone bankrupt or refused to pay.  In such a situation the debtors will have a write-off which would result in a dip in current assets. 
  • Loss in inventory by accident can also lead to negative working capital. 
But for example- financing a fixed asset by cash will make a hit at current assets position but it is a sign of efficiency where you are able to make investment in fixed assets by using internally generated funds!
  • So this is an instance of a favourable negative working capital.
Working capital is a critical factor to consider in assessing the financial health of any business vis. a vis. the efficient use of its resources.

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