Management of working capital

Working capital

Working capital is defined as the excess of current assets over current liabilities, otherwise known as net current assets. The current ratio can be defined as:

Current assets / Current liabilities

and thus a frequently quoted ideal ratio is 2:1. It is this excess of current assets over current liabilities that provides the business with the capital it needs to carry on its day-to-day activities. The management of working capital can be crucial to the survival of a business.

Management of working capital

The main objectives in the management of working capital can be summarized as follows:

1 To keep the time lag between the input of resources into production and the payment for goods and services produced as short as possible. This will reduce the amount of current assets (stocks, debtors and cash) the business needs to invest in at any one time. The same amount of investment is working harder.

2 The financing should be kept as efficient as possible to ensure the greatest possible return on capital employed.

The management of working capital is the application of common sense. They are the principles used by any person managing her/his income.

• Do not borrow too much money when the ability to repay debts depends upon uncertain income. If a business is relying on people who owe it money to be able to meet its own liabilities, then the failure of one person to pay will cause problems.

• Do not borrow on a short-term basis to finance medium- or long-term purchases: the short-term loans might dry up. The technical term for this is overtrading.

• Do take into account the opportunity cost. This service/course of action might appear expensive, but what are the hidden advantages (i.e. cost reductions) for the business?

• Ultimately, for a business as for an individual, the question is: Will it be able to meet its debts?

The effective management of working capital depends upon the co-operation of all the departments in a business. We can use the control of stock level as an example of this.

The valuation of stocks is usually based on the cost of stocks or their net realisable value (that is what the business would receive if it sold them on the open market), whichever is lower. However, the level of stocks held will also depend on a number of other factors, for example:

• the ability of the purchasing department to maintain a flow of necessary supplies at a rate linked to their usage. If purchasing is erratic the business may have to hold higher stocks than is strictly necessary.

• the expertise of the marketing department in estimating future demand and the ability of the production department to maintain a steady flow of production to meet that demand. Overestimating demand can lead to a build-up in stocks of finished goods and, if production is reduced, the build-up of raw materials and components.

2. Comprehension check.

Working in pairs, answer the questions.

1. What is working capital?

2. Can you give the main objectives in the management of working capital?

3. What principles does any person managing her/his income follow?

4. What factors does the efficient management of working capital depend on?

3. Read text again. Find and write down words in the text that mean the same as the following words and definitions. They are in the same order as they appear in the text.

a. circulating capital	b. to refer to	c. decisive, determinant
d. expenses	e. to exhaust	f. when a business has expanded in such a way that it lacks sufficient working capital and so suffers liquidity problem
g. the process or result of making something smaller or less in amount size, importance	h. after a process or activity has ended	i. reserve rate
j. changing often or not following a regular pattern, so that it is difficult to know what will happen next	k. accumulation

Discussion

Work in small groups.

Discuss:

1. how can an analysis of the accounts of a business help a potential investor judge the efficiency with which the working capital is managed by a business;

* b) disadvantage(s) of attempting to overcome problems related to working capital by increasing the current liabilities of the business;

c) the role of a production department in improving working capital.

Unit 8

Money matters and payment.