Accounts & Finance

Working Capital

Learning Objectives

Define working capital and explain the working capital cycle

Prepare a cash flow forecast from given information

Evaluate strategies for dealing with liquidity problems

Working Capital

• Every business NEEDS cash to function• Cash is needed for everyday expenses such as

wages and buying stock• Without sufficient working capital (cash) a

business will be illiquid (unable to pay its immediate or short term debts – these are their liabilities – creditors, overdrafts)

• It may be forced into liquidation

Cash inflows and cash outflows

• Cash inflows – payments in cash received by a business

• Cash outflows – payments in cash made by a business

• Work with a partner and list 3 cash inflows and 3 cash outflows that a business may experience

Main types of cash inflows and outflows

• Cash flow can be described as a cycle:

• The business uses cash to acquire resources (assets such as stocks)• The resources are put to work and goods and services produced. These are then

sold to customers• Some customers pay in cash (great), but others ask for time to pay. Eventually they

pay and these funds are used to settle any liabilities of the business (e.g. pay suppliers)

• And so the cycle repeats• Hopefully, each time through the cash flow cycle, a little more money is put back

into the business than flows out. But not necessarily, and if management don’t carefully monitor cash flow and take corrective action when necessary, a business may find itself sinking into trouble.

• The cash needed to make the cycle above work effectively is known as working capital

Where does Working Capital come from?

• Simple calculation

Current assets – current liabilities

Current assets are?

Current assets = Cash + Stock + Debtors

Current Liabilities are?

Current liabilities refers to the money a business owes that needs to be repaid within the next 12 months. E.g. Overdrafts, Creditors, Tax

Calculating Working Capital

• If you’re showing current assets of £100,000 and current liabilities of £80,000, your working capital is……?

• £20,000

• While any current assets are great, cash is better - especially now!

Why?

Managing working capital

• The objective of managing working capital is to ensure there is always enough cash on hand:

– to pay bills as they become due, – to purchase enough inventory and stock to meet

demand – and to have enough sales to support expenses.

Cash management

• Cash management is an essential, yet often neglected, component of business management

• We have all heard the statement that "most companies do not fail from lack of profit, but from lack of cash"

• It is also true that a period of dramatic sales increases will most likely be a company's most profitable, but will also likely be the period of greatest cash flow needs

Remember

Current assets – Current liabilities

How much working capital should a business have?

• It depends on:– Volume of sales– Size of trade credit offered to it– Whether the business is expanding or not– Length of operating cycle (from paying for raw materials

to receiving payment from customers)– The rate of inflation

Factors affecting level of working capital

Factor Explanation

Need to hold inventories (stock)

Some businesses need to hold substantial inventories to meet customer needs – e.g. retailers and distributors

Production lead time

A product that is made and sold within a short time (e.g. fresh food) requires much less inventory than one where the production process takes a long time (e.g. production of mature cheese!)

Lean production Businesses that successfully implement lean production techniques find that they need to hold significantly less inventory

Customer credit period

In some industries it is expected that a long credit period can be taken before trade debtors need to settle their invoices – which means that higher working capital is required

Effectiveness of credit control

A poorly managed credit control department will allow customers to take too much credit and take too long to settle their bills – which will mean higher trade debtors and higher working capital

Supplier credit period

The longer the credit offered by suppliers, the better for cash flow and working capital.

WORKING CAPITAL

THE LIFEBLOOD OF A BUSINESS

Capital & Revenue Expenditure

• Capital expenditure – on items that will be used time & time again, that will continue to help the business in the following years – is known as capital expenditure

• Revenue expenditure – spending on day to day items for the running of the business.

Need Working capital for this

• REVENUE expenditure

Or

• CAPITAL expenditure ?

Is this Capital or Revenue Expenditure?

Marketing expenditure

Revenue Expenditure

Is this Capital or Revenue Expenditure?

New fleet of company cars

Capital Expenditure

Is this Capital or Revenue Expenditure?

Ink cartridges

Revenue Expenditure

Is this Capital or Revenue Expenditure?

Inventories

Revenue Expenditure

Is this Capital or Revenue Expenditure?

Office Equipment

Capital Expenditure

Is this Capital or Revenue Expenditure?

Salaries

Revenue Expenditure

Is this Capital or Revenue Expenditure?

New factory

Capital Expenditure