3 – Working Capital

The Working Capital Cycle



Production Costs

Working capital is how much money the business has for the day-to-day running costs of the business, also called net current assets. This covers things like wages, raw materials, etc. Current assets include things like cash, debtors and stocks, whilst current liabilities include overdrafts, creditors and taxes.

Since there is always a delay between each stage of the cycle, the business needs to manage their working capital well to ensure they are able to cover their costs. When a business does not have sufficient working capital, they do not have good liquidity. Note that they may still be making a profit, even though they are low on working capital. At the same time, the business can be too liquid, as this is wasteful, and the money could be better invested elsewhere, such as growth.


Cash-Flow Forecasts
A cash-flow forecast will try to estimate the movement of money during a set time period, etc. This is used for planning purposes, based on past experience. The forecast will analyse the inflows of cash from sales revenue, debtors and interest on bank deposits. The outflows include bills, labour, rent, etc. The net cash flow is then found from the difference between these two. Cash-flow forecasts are used by bank to decide about loaning to the business, help managers to respond to liquidity problems and planning for objectives, etc. Note that negative numbers should be shown in brackets. Cash Flow Forecast for Business XX Jan Receipts Cash Sales Revenue Other Income Total Receipts Costs Labour Rent Other Costs Total Costs Net Cash Flow Opening Balance Closing Balance The opening balance for one month is always the same as the closing balance for the previous month. The closing balance is calculated using the opening balance, and adding the net cash flow. Feb Mar Apr May Jun


Limitations of cash flow forecasts include:  Possibly inaccurate predicted sales  Demoralised workforce causing other conflict  Failure at an operational level causing delays  Unpredictable behaviour of competition  Changing trends and demand  Unforseen economic changes  Other external shocks

Management of Working Capital
Cash and profit are two very different things, and should not be confused. Profit is the revenue minus the costs of sales. Hence, the business may be making a profit on their sales, but the delay in payment, such as with credit, may mean that they do not have much cash. At the same time, a business may have a lot of cash, but not make a profit. Cash flow problems can happen for a number of reasons:      Overtrading, where the business expands too quickly and do not have the resources They cannot meet their loan repayments due to overborrowing They may hold too much stock, called overstocking, bringing waste, storage and production costs. Poor credit control, meaning that too many customers owe the business money There may be unforseen changes, both internal and external.

To deal with these problems, the business may seek alternative sources of finance:     Seek overdrafts to temporarily cover their costs Selling their fixed assets and then leasing them back, called sale and leaseback Selling off fixed assets that are not being used Using debt factoring to partially recover losses incurred from bad debt.


The business may be able to seek government assistance in the form of grants, etc to reduce their costs

They may use growth strategies to increase their size

They may also try to improve their cash inflows:      Tighter credit control to reduce the debtor period They may choose to accept cash payments only Change the pricing policy to turn stock into cash faster They may try to improve their product portfolio to generate more sales The business may also improve their marketing planning to better meet the needs and wants of their customers Finally, they may reduce their cash outflows:     Seek preferential credit terms form their creditors Use alternative suppliers to lower costs Change their stock control system to increase liquidity Analyse their expenses in order to identify cost reducing measures

For the best results, a combination of the above techniques may be used. Firms should also have a contingency fund for emergency use. Other measures include: o Spreading risks to increase customer base o Demanding payments at key intervals of long projects o Paying bills in regular instalments o Putting quality management in place to prevent wastage and losses


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