5.1. Meaning of Working Capital
There are several technical definitions of working capital, some being complex and difficult to break down. However, the simple definition of working capital can be given as the money that is available for a firm to meet its current, short term obligations. It can also be defined as the difference between a company’s current assets and current liabilities. It is a tool used to measure financial performance of a company by calculating whether the company has enough liquid assets to meet its short-term financial obligations such as payment of bills and salaries.
A company’s current assets include cash and cash equivalents, inventory, accounts receivable (debtors), and marketable securities. These are the assets that a company can easily convert into cash use to pay short term financial obligations.
Current liabilities are the amount of money that a business owes, such as creditors (accounts payable), short-term loans, and accrued expenses.
Working capital is derived by subtracting current liabilities from current liabilities as shown below:
In the figure, the total current assets of the firm is $80,000 while the total current liabilities is $40,000. This gives a working capital of 80,000-40,000 = 40,000.
Working capital is the measure of a firm’s liquidity, which refers to the ability to meet short term obligations as they fall due. It can be used in financial analysis to assess the company’s performance. A company that has a high working capital is able to meet its financial debts. It means that the firm has enough liquid assets that can be used to pay off bills; hence the firm can pay creditors, employees, suppliers, and other short term financial obligations.
A positive working capital is a good sign which shows that the firm has a good financial health, at least in the short term. A company that has a positive working capital can be able to run its operations effectively; it shows that the company’s operations are efficient, and the company can internally pay for its bills and finance business growth. However, a negative working capital means that the firm’s current assets are not sufficient to pay off all current liabilities. As a result, the firm has to borrow to meet its short-term financial obligations. As debts increase, so do financing costs. This shows a negative financial position for the company, which may not be good for the company’s operations and relations with shareholders.
The amount of working capital a company has will typically depend on its industry. Some sectors that have longer production cycles may require higher working capital needs as they don’t have the quick inventory turnover to generate cash on demand. Alternatively, retail companies that interact with thousands of customers a day can often raise short-term funds much faster and require lower working capital requirements.
5.2. Components of Working Capital
Based on the formula of calculating working capital in section 5.1, we can identify some of the key components of working capital. These components are current assets and current liabilities. The components of working capital can be found in the company’s balance sheet.
Current assets are economic resources that the company currently holds or are expected to be earned within the next 12 months; and which can be easily turned into cash. They are short-term assets that a company is able to liquidate into cash easily within one year. Current assets are needed to run day-to-day operations and pay current expenses. Current assets are important items in a company’s balance sheet, and their value is calculated at the current market price. The types of current assets include:
- Cash and Cash Equivalents: Money that a company has at hand as well as foreign currencies, money market accounts, and cash held at bank.
- Inventory: Also known as stock; unsold goods that are being stored as they await to be sold. It includes raw materials used to produce goods, goods bought for resale, and finished goods that have not been sold.
- Accounts Receivable: Debtors; all money that customers owe the company for purchasing inventory on credit. For example, let’s say you sold books to a bookshop on credit with the agreement that they will pay full amount in 3 months. The money owed is recorded on the balance sheet as accounts receivable.
- Notes Receivable: All of the claims to cash for other agreements, often agreed to through a physically signed agreement.
- Prepaid Expenses: These are expenses that have been paid in advance. For example, when you pay rent for three months in advance, it is categorized as prepaid expense.
Current Liabilities are the debts that a company owes, which are payable within the next 1 year. The concept of working capital is used to establish whether a company is able to pay off such debts in full within the year. Some types of current liabilities are:
- Accounts Payable: all unpaid bills owed to third parties for raw materials, utilities, rent, and other operating expenses. This includes money owed to suppliers for the purchase of raw materials on credit.
- Wages Payable: These are unpaid wages and salaries owed to employees. They are usually money accrued for one month.
- Short Term Loans: Bank loans that last for less than 1 year are considered as current liabilities. This includes current portion of a long term debt that is payable in the next 12 months.
- Accrued Tax Payable: This refers to the obligations owed to the government in the form of tax. They include accruals for tax obligations/
- Dividend Payable: These are money owed to shareholders as accrued dividend payments.
- Unearned Revenue: All money or capital received before services or products are delivered to the customer are referred to as unearned revenue. If the company fails to deliver the service, they may be forced to pay back all the capital received in advanced.
5.3. Role of Working Capital in a Firm
Working capital plays a significant role in the management of a company’s resources. Companies that are making losses might have been profitable if they found a way to manage their working capital more efficiently. Working capital is important for a business in the following ways:
- Determining Liquidity of the Firm: managers calculate working capital to determine whether the firm has sufficient liquid assets that can easily be turned into cash to pay off financial obligations as they fall due.
- Promoting Efficiency: Having a positive working capital ensures that the company can operate normally and more efficiently. Without cash, the company may experience delays in payments, customer complaints, and other operational issues.
- Enhancing good cash flow: working capital ensures that the firm has a positive cash flow where incoming cash is higher than cash outflows. Having a positive working capital means that the firm has enough cash to use in daily business operations.
- Expansion/growth: working capital can be used to achieve business growth. For example, having enough cash and inventory enables the firm to expand to new markets and sell more products in existing markets. In this case, working capital can be used as a source of finance for investment and expansion purposes.
- Increased Profits: Working capital management enables a company to increase its profitability. This can be done by saving on financial costs that could have been incurred if there was no working capital to pay off current liabilities.
- Availability and Proper Utilization of Resources: Working capital ensures that the company has sufficient cash to acquire resources and maintain existing resources. For instance, maintaining an optimal level of stock ensures that the company can meet demand at all times. There must be enough cash to purchase new stock when the current stock is depleting, and to maintain motor vehicles and equipment.
- Promotes the company’s going Concern: a going concern is a situation in which a business has a good financial health and can be able to meet its obligations and continue operating for a long time into the foreseeable future. Without sufficient resources, the company can easily go out of business and lose its going concern. Working capital enables the company to continue operating for a longer period in the foreseeable future.
- Promotes Positive Stakeholder Relations: a company with a positive working capital is able to satisfy its stakeholders such as customers, suppliers and shareholders. For instance, having enough working capital means that the firm can pay its suppliers and creditors on time; hence improving relationships with those stakeholder groups.
5.4. Sources of Financing Working Capital
Working capital allows companies to finance and grow their businesses without the need for more expensive outside sources of funding. It includes current assets minus current liabilities. Thus, financing working capital involves increasing current assets and reducing liabilities. Accumulation of current assets can be done through financial transactions e.g. sales and retained earnings. Retained earnings is the primary source of current assets, which forms an important part of working capital. The key sources of working capital financing include:
- Retained Earnings: these are the amount of money that a company retains from its annual profits after paying shareholders and creditors. Retained earnings are added to the company’s balance sheet as current assets.
- Bank Overdraft: When a company is running short of cash for operations, it can borrow a certain among of money above the amount they have withdrawn. This is required when they need cash to run business operations or meet short term financial obligations as they fall due.
- Accounts Receivable: Accounts receivable or debtors can be turned into cash to meet working capital requirements of the company. Many banks, as well as non-banking financial companies, may provide businesses with invoice discounting facilities to get quick cash from their debtors.
- Customer Advances: Working capital can also be financed by allowing customers to pay for goods in instalments. When a customer pays deposit for an item without taking possession of that item, the company gets liquid cash to run its daily operations.
- Long-Term Loan: A company can take long term loans when their working capital is depleting and there is no other short term source is available. A long term loan from a bank covers more than 12 months.
- Debentures and Equities: Business firms can also turn to investors to fund their working capital. Shareholders, bondholders and other investors can provide funding for the company through bonds, debentures or equity.
5.5. Mechanism of Controlling Working Capital
By the end of this section, the learner should be able to discuss how a company can adjust its working capital.
The mechanisms used to control working capital involves adjusting the components of working capital, which are current assets and current liabilities. A company can increase working capital by either increasing current assets or decreasing current liabilities, or both. Let’s use this example:
Suppose we have current assets of KES 100,000 and current liabilities of KES 40,000. The working capital will be 100,000-40,000 = 60,000. Let’s say the company’s employees worked hard to generate more cash of KES 10,000 through sales. This means that the current assets will increase to KES 110,000 and WC will rise to KES 70,000 (110,000-40,000). Some of the mechanisms that a company can use to control the components of working capital are:
Cash Management: this involves collecting and managing cash flows to ensure that the cash balance is enough to run business operations. A company can increase working capital by looking for ways to generate more cash.
Inventory Management: inventory management refers to the process of controlling inventory or stock by ordering, storing, using, and selling them. As part of current assets, increasing inventory leads to increased working capital. Inventory can be increased by ordering more raw materials. However, the firm should ensure that it has only enough stock to meet existing and future demand.
Debtors Management: This involves collecting debts in time and avoiding bad debts. A company can manage debtors by discounting the debt through a bank. A company can also use appropriate credit policy and create the right credit terms to attract customers while at the same time minimizing bad debts.
Financing Management: Financing management involves choosing appropriate sources of financing, which will ensure that there is a good flow of cash in the company. Financing options such as short term and long term bank loans can affect the components of the working capital.
Operations Management: Operations management involves controlling the processes involved in producing goods and delivering services to customers. Business operations should be managed well to achieve efficiency, reduce wastes, and ensure proper utilization of current assets to meet pay the current liabilities.