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Working Capital – The Lifeblood Of Business

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Working Capital - The Lifeblood of BusinessWorking capital is the life blood of the organisation, but what is it? A business’s working capital is the amount in liquid assets a company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth. Net working capital is usually calculated by subtracting current liabilities from current assets.

Key Components Of Working Capital

On the asset side, the key components of working capital are:-  

  • Stock: This is the most illiquid of the components of working capital. Stock can range from the components used in the manufacturing of a product to stocks of the finished goods themselves;

  • Receivables:  The amounts due from customers to the business after they have sold the goods; and

  • Cash: The most liquid form of working capital. For the most part, cash is available immediately.

On the liability side the two key components are:-

  1. Trade payables: The amount owed to your suppliers;

  2. Borrowings: Funds advanced by a lender to assist the business to be funded.

How Much Working Capital Do You Need?

The key failure for a start up business is not the fact that they do not make profit but that they do not have the necessary funding in place to support their working capital needs. It is important to understand the business cycle and how this impacts the working capital needs.

The stages in the cycle:-

  • An order is placed;

  • Goods are purchased;

  • Goods are manufactured;

  • Goods are paid for;

  • Goods are sold; and

  • Cash is collected.

The cycle then starts all over again.

Even in the simple example above, it can be seen that cash flows out before cash comes in. Therefore, for any business there is a need to have cash available to fund the business. A situation where there is a shortage of cash before the cash is returned is referred to as a ‘funding gap’.

How Much Working Capital Is Required?

Consider the following scenario:

Materials are purchased on 30 days credit. It takes a week to manufacture the goods and the goods are in the warehouse a week before being sold. Sales are on 30 days credit. Wages and overheads are paid on the last day of the month.

In this scenario:

Day 1

Goods Purchased

€100

Day 14

Goods Sold

€200

Day 30

Goods Paid For

€150

Day 30

Wages & Overheads Paid

€25

Day 44

Cash Received

€200

Despite being profitable the company needs to be able to fund €175 for a 14 day period before they are in funds. This funding may have come from the initial cash put into the business or through an overdraft facility.

In an on-going business, the funding gap may not be as easily visible as there is a continuous flow of cash. The real evidence of a funding gap problem would be an increasing overdraft requirement which is fine if it is available. However, a business cannot continue to grow and not put in place some strategy to close the gap.

There are mathematical models that can be used to calculate the funding requirement.

How Is The Gap Closed?

If other funding, e.g. overdraft, borrowing, is not available, then the only way the company can continue is through changing its terms – either by extending the credit taken or by shortening the credit given. That is not an area that a new business may have much control over. The day to day management of working capital is therefore an important tool in the managing of any business.

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