Working Capital

Description of Working Capital. Explanation.

Definition Working Capital. Description.

Working Capital is the amount by which current assets exceed current liabilities. It is used to fund the operations of a company or non-profit organization, such as purchases of raw materials, office supplies, salaries, etc.

It can be regarded as the lifeblood of a business, because it is needed to finance the cash conversion cycle of a business: the number of days required to convert raw materials into finished goods, finished goods into sales, and accounts receivables into cash.

Along with fixed assets (such as plant and equipment), working capital is considered a part of operating capital.

Working Capital Deficiency

If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit. A positive working capital is vital to ensure that a firm is able to continue its operations and that it has sufficient funds available to satisfy both maturing short-term debt and upcoming operational expenses.

The Meaning of an Increase or Decrease of Working Capital

An increase in working capital indicates that the business has either increased current assets (that it has increased its receivables, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.

How much Working Capital is Needed?

The amount of working capital needed varies with a number of factors, including: type of industry, efficiency of production processes, economies of scale, seasonality, sales success, etc. A (temporary) shortage in the working capital can easily lead to bankruptcy of a small firm, even if it has many profitable orders coming. In debt contracts, the borrower may be obliged to maintain certain levels of working capital. Such clauses are called Affirmative Debt Covenants.

Sources of Working Capital

Internal sources include: retained earnings, savings through achieving operating efficiencies, allocation of cash through depreciation, deferred taxes.

External sources include: short-term borrowings, trade credit, accounts receivables factoring.

Working Capital Management

This involves managing the relationship between a firm's short-term assets and its short-term liabilities via a combination of policies and techniques, such as cash (flow) management, inventory management, debt management and short term financing. The aim of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses.

Working Capital Forum (2)

What is the Meaning of a Low or High Average Collection Period?
"Most firms allow their customers to purchase goods or services via credit. There is nothing wrong with this business practice. But one problem with allowing to buy on credit is there are risks and costs associated with doing so. In indivudual cases you don't always know if and when a customer will make cash payments.
Possessing a low average collection period (compared to industry benchmark) is normally a positive sign, because it means that it does not take the company very long to turn its receivables into cash.
A relatively high average collection period (compared to industry average) may indicate:
1. Poor credit decisions,
2. High profit levels,
3. Slow / poor collection of accounts receivables,
4. Low liquidity levels."

Marginal Profitability from relaxing Credit Policy
"Suppose the annual sales of XYZ Ltd. is Rs. 24,000,000. After 6 months an account is turned over to a collection agency and on average one percent of the total receivable volume under the present credit policy is never received by the firm. The current policy and the expected effects of two proposed policies, A and B, are compared in following table:
Present Policy / Policy A / Policy B
Additional demand (Percentage) 0 / 25 / 35
Average collection period 1 month / 2 months / 3 months
Default losses (Percentage) 1 / 3 / 6
Determine the marginal profitability from relaxing the credit policy:
- from the present policy to policy A and then from policy A to policy B
- by comparing the marginal profitability to the required rate of return (20%) on additional investment in receivables."

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