Saturday, 20 June 2009

Working Capital Cycle & Working Capital Management

Working Capital

This measures the funds that are readily available to operate a business.

Working capital comprises the total net current assets of a business, which are its stocks, debtors and cash - minus its creditors.

Why it is important

It is vital for a company to have sufficient working capital to meet all its requirements. The faster a business expands, the greater will be its working capital needs.

If current assets do not exceed current liabilities, a company may well run into trouble paying creditors who want their money quickly.

Indeed, the leading cause of business failure is not lack of profitability, but rather lack of working capital, which helps to explain why some experts advise: 'Use someone else's money every chance you get and don't let anyone else use yours.'

How it works in practice

Working capital is also called net current assets or current capital.

Working capital = Current assets - Current liabilities

Current assets are cash and assets that can be converted to cash within one year or a normal operating cycle; current liabilities are monies owed that are due within one year.

What is working capital cycle

The working capital cycle describes capital (usually cash) as it moves through a company:

  • it first flows from a company to pay for supplies, materials, finished goods inventory, and wages to workers who produce goods and services.

  • It then flows into a company as goods and services are sold and as new investment equity and loans are received.
Each stage of the cycle consumers time.

The more time the stages consume, the greater the demand on working capital.

Cash ----> pay for supplies, materials, finished goods inventory and wages to workers who produce goods and services ---> goods and services are sold and new investment equity and loans are received ---> Cash

Tricks of the trade

- Good management of working capital includes action like collecting receivables faster and moving inventory more quickly; generating more cash increases working capital.

- While it can be tempting to use cash to pay for fixed assets like computers or vehicles, doing so reduces the amount of cash available for working capital.

- If working capital is tight, consider other ways of financing capital investment, such as loans, fresh equity, or leasing.

- Early warning signs of insufficient working capital include:

  • pressure on existing cash;
  • exceptional cash generating activities such as offering high discounts for early payment;
  • increasing lines of credit;
  • partial payments to suppliers and creditors;
  • a preoccupation with surviving rather than managing;
  • frequent short-term emergency requests to the bank, for example, to help pay wages, pending receipt of a cheque.

- Several ratios measure how effectively and efficiently working capital is being used. (Key Working Capital Ratios : Stock Turnover(in days), Receivables Ratio(in days) , Payables Ratio(in days) , Current Ratio, Quick Ratio, Working Capital Ratio)

Also read:

Working Capital Management

Working capital management involves the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.