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WorkingCapital
Introductiontothe
Managementof
WorkingCapital

AS&A2BusinessStudies
PowerPointPresentations2005

Introduction
Allbusinessesneedcashtosurvive
Cashisneededto:
Investinfixedassets
Paysuppliersandemployees
Fundoverheadsandotherfixedcosts
PaytaxduetotheGovernment

Nearlyallbusinessesusemuchoftheircashresources
tofinanceinvestmentinworkingcapital
Managingworkingcapitaleffectivelyis,therefore,a
vitalpartofmakingsurethebusinesshasenoughcash
tocontinue

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WhatisWorkingCapital?
WhatisWorkingCapital?

Workingcapitalisthecashneededto
payforthedaytodayoperationofthe
business
HowisItCalculated?

Workingcapitalisthedifference
betweenthecurrentassetsofa
businessanditscurrentliabilities
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DefinitionofWorkingCapital

Current
Assets

Assetsofthebusiness
heldincashform(e.g.
atthebank)orthatthat
canquicklybeturned
intocash

Less

Current
Liabilities

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Moneyowedbya
businesswhichwill
needtobepaidinthe
next12months

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DefinitionofWorkingCapital
Stocks

Current
Assets

Debtors
Cash
Investments

Less
TradeCreditors

Current
Liabilities

Taxation
Dividends
ShorttermLoans

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CalculatingWorkingCapitalExample

Current
Assets

Less

Current
Liabilities

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Stocks

250,000

TradeDebtors

500,000
900,000

Cash

125,000

Prepayments

25,000

WorkingCapital=
TradeCreditors

350,000

Taxation

100,000

250,000

650,000
Dividends

50,000

ShorttermLoans

150,000

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TheWorkingCapitalCycle
Notallbusinesseshavethesameneedtoinvestin
workingcapital
Muchdependson
(1)Thenatureoftheproductionprocess(i.e.whatandhowsomething
isbeingproduced),and
(2)Thewayinwhichtheproductisdistributedtocustomers

Theworkingcapitalcycleis:
Theperiodoftimebetweenthepointatwhichcashisfirstspenton
theproductionofaproductandthefinalcollectionofcashfroma
customer

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WorkingCapitalCycleIllustrated
RawMaterialsorderedfrom
suppliersandputintostock
awaitingproduction.Cash
isuseduptofinancestocks
(bypayingthesuppliers)

Finallytheproductstartsto
generatecashas
customerspaytheamounts
theyowe.Thenthewhole
processstartsagain

Morecashisusedtofinance
theproductionprocess
employstaff,runthefactory
andothersupportoperations

Morecashisuseduptostore
finishedproductsanddistribute
themtotheintendedmarkets.
Tradecustomersareallowedto
buynowandpaylaterso
debtorsincrease

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WorkingCapitalRatios(liquidity)
Theliquiditypositionofabusinessreferstoitsability
topayitsdebtsi.e.doesithaveenoughcashtopay
thebills?
Thebalancesheetofabusinessprovidesasnapshot
oftheworkingcapitalpositionataparticularpointin
time
Therearetwokeyratiosthatcanbecalculatedto
provideaguidetotheliquiditypositionofabusiness
Currentratio
Acidtest(quick)ratio

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CurrentRatio
CurrentAssets

Calculation
Formula

CurrentLiabilities

ExampleCalculation
000
Stocks

1,125

Tradedebtors

1,750

Cashbalances

650

CurrentAssets

3,525

TradeCreditors

1,025

Othershorttermliabilities
CurrentLiabilities

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3,525

2.8

1,260

235
1,260

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AcidTest(Quick)Ratio
CurrentAssets(lessStocks)

Calculation
Formula

CurrentLiabilities

ExampleCalculation
000
Stocks

1,125

Tradedebtors

1,750

Cashbalances

650

CurrentAssets

3,525

TradeCreditors

1,025

Othershorttermliabilities
CurrentLiabilities
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2,400

1.9

1,260

235
1,260

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InterpretingtheRatios
Abusinessneedstohaveenoughcash(orcashtocome)tobe
abletopayitsdebts
Obviously,acurrentratiocomfortablyinexcessof1shouldbe
expectedbutwhatiscomfortabledependsonthekindof
business
Somebusinessesfindithardtoturnstockanddebtorsintocash
soneedahighcurrentratio
Somebusinesses(e.g.supermarkets)turnstockintocashvery
rapidlyandhavelowdebtorssotheycanhappilyexistwitha
currentratiooflessthan1
Theacidtestratioisoftenconsideredtobeabettertestofliquidity
forbusinesseswithalowstockturnover

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LimitationsofLiquidityRatios
Liquidityratiosshouldbeusedwithcare
Balancesheetvaluesataparticularmomentintime
maynotbetypical
Balancesusedforaseasonalbusinesswillnot
representaveragevalues
Ratioscanbesubjecttowindowdressingor
manipulation(e.g.abigpushtogetcustomerstopay
outstandingbalancesbytheyearend
Ratiosconcernthepast(historic)notthefuture
Workingcapitalmanagementisverymuchabout
ensuringthebusinesshassufficientcashinthefuture
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DangerofOvertrading

Overtradinghappenswhena
businesstriestodotoomuch,too
quicklywithtoolittlelongterm
capital
Warning:aprofitablebusinesscan
failifitrunsoutofcash

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OvertradingIntroduction
Overtradingrepresentsanimbalancebetweenthe
ordersabusinessacceptsandthemeansithastofulfill
them
Overtradinghappenswhenabusinesstakeson
customerorders,butdoesnothaveenoughcurrent
assets,orworkingcapital,tomeetthesedemands
Overtradingisparticularlycommoninyoung,rapidly
expandingbusinesses.Itcanbeextremelyserious,
evenfataltothebusiness

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HowdoesOvertradingHappen?
Thelengthoftheworkingcapitalcyclegetslonger
E.g.tradedebtorsstarttakinglongertopaytheirdebts
E.g.stocksareorderedearlierandneedtobepaidforbeforethey
aresold
E.g.suppliersinsistonbeingpaidearlier

Businessturnover/outputincreases
E.g.morestockisrequired(rawmaterials,greatervalueofworkin
progress)
E.g.thevalueoftradedebtorsgrowsinlinewithhighersales

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SymptomsofOvertrading
Rapidincreaseinsales/turnover
Rapidincreaseinthevalueandvolumeofcurrent
assets(e.g.increaseinstocks)
Reductioninstockturnoverandincreaseinaverage
timetakenbydebtorstopayinvoices
Onlyasmallincreaseinownerscapitalwithmostof
theadditionalfinancecomingfromhighertrade
creditors(borrowingfromsuppliers)andthebank
Significantfallinkeyliquidityratios(currentratio/
quickratio)

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OtherSourcesofLiquidityProblems
Internalcauses
Poormanagementofoperations(e.g.allowingtoomuchstocktobe
boughtandstockpiled)
Productionproblems(e.g.equipmentfailuredelayingtheprocessing
ofrawmaterialsintofinishedgoods,orpoorqualitystandards)
Poormarketingdecisions(e.g.allowingcustomersunsuitablylong
credittermsfailureofpromotionalcampaignsleavingthebusiness
withunexpectedlyhighstocks)

Externalcauses
Economic:e.g.unexpectedlylowerdemandduetofallingcustomer
confidenceorchangeinexchangerates
Financialfailure:e.g.tradedebtorsgoingoutofbusinessleaving
theirdebtsunpaid

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WaystoImproveLiquidity
Option

Pitfalls

Reducethestockholdingperiodfor
finishedgoodsandrawmaterials

Mayresultinproductiondelaysorshortagesifdemand
increasesunexpectedly

Improvetheefficiencyoftheproduction
process(e.g.shortenbyusingbetter
productionmethods)

Costlytoreorganiseproductionbutmaybeworthitinthe
mediumterm

Reducethecreditperiodofferedtotrade
debtorsandchaseamountsduemore
aggressively

Mayupsetcustomersorcausethemtoreducetheamount
theybuy

Extendthetimetakentopaycreditors

Adangerousoptionsuppliersmayrefusetosupplyormay
chargeinterestiftheirpaymenttermsareexceeded

Useinvoicediscountingordebtfactoring Agoodwaytoobtaincashquicklybutusuallycostly(e.g.
factoringfirmchargesahighcommissionondebtspaid)
toobtaincashfromtradedebtors
Saleandleasebackofassets

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Anothergoodwayofreleasingcashfromfixedassetsbut
leavesthebusinesswithhighercostsandpaymentobligations

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KeyTerms
Workingcapital

Fundsrequiredbythebusinesstopayforthedaytodayoperationofthebusiness

Workingcapital
cycle

Theperiodoftimebetweenthepointatwhichcashisfirstspentontheproductionofa
productandthefinalcollectionofcashfromacustomer

Currentassets

Assetsofthebusinessheldincashform(e.g.atthebank)orthatthatcanquicklybe
turnedintocash

Currentliabilities

Moneyowedbyabusinesswhichwillneedtobepaidinthenext12months

Liquidity

Theabilityofabusinesstopaywhatitowesasthoseamountsbecomedue.Abusiness
thatdoesnothaveenoughcashisdescribedasilliquid

Currentratio

Measureofliquiditybasedondatafromthebalancesheet.Calculatedascurrentassets
dividedbycurrentliabilities

Acidtestratio

Anotherliquidityratiobettersuitedtoassessbusinessesthathavealowstockturnover

Overtrading

Whenabusinesstakesontoomanyobligationswithouthavingthefinancetopayforthem

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