The first question that’ll come to the mind of someone that is not financially literate is what is Working Capital? It shouldn’t come as a surprise that this person may just be a business owner engaged in a form of trade. As a business owner, consciously or unconsciously, whether we’d like to admit it or not, you have tried to manage your working capital. Most Sole Proprietors do this without even knowing that the act they are carrying out is Working Capital Management.
Alright, let’s explain what this term Working Capital is, so that we can carry everybody along. How about that? In simple terms, Working Capital is simply CURRENT ASSETS less CURRENT LIABILITIES. In other words, it is the excess of current assets over current liabilities. Current Assets constitutes Cash at hand or at bank, account receivables or debtors and your inventory. While, Current Liability constitutes your Account payables or creditors, bank overdrafts, salaries or expenses owed (accrued expenses).
Breaking it down, Working Capital is the difference between the amount of your Current Asset your company has and the amount of your Current Liability, this difference could be negative or positive, thus, the names, Negative working Capital and Positive Working Capital. Your Working Capital could even be zero, this scenario could occur when all your Current Assets were financed from your Current Liability. A positive Working Capital occurs when there are more Current Assets than Current Liabilities and the reverse is true for a negative Working Capital.
Okay, so now that we are on the same page, lets up the tempo a little bit shall we?
For some businesses or Companies, managing the Working Capital of the organization is a difficult task and an important one at that, so important that they hire or employ Management Accountants just for that sole purpose. The importance of managing your working capital can’t be overemphasized, if done wrongly, your company that you’ve built for years may just come crumbling down in a matter of days. Sad isn’t it? But why is it so? Simple, the reason is because Working Capital and the liquidity level of your business works in pari passu. If your working capital level is okay then most times your liquidity level would be good and vice versa. Working Capital is the lifeline of a business, it affects the finances of your business in more ways than you can think of. A successful business would always strive to achieve an optimum level of working capital.
The truth is having a negative working capital is not always bad, likewise, having a positive Working Capital is not always good either. Did I lose someone there? Or how’s it a bad thing if I have my way, more Current Assets than Current Liabilities? Oh yes, it can definitely be a good thing if you have a negative Working Capital, that is if and only if you know what you’re doing. I’d like to call that The Art of Working Capital Management.
No doubt, having enough working capital ensures a company can fully cover its short term liabilities when they fall due within the next 12 months, it’s a sign of a company’s financial strength. However, having too much working capital in uncollected accounts receivables and unsold or unused inventories is not exactly an effective way of managing your business’ vital resources, in fact this is the secret that retail giants Shoprite, Spar etc. would not tell you. As a business owner or store owner, in relation to your working capital, you should work towards achieving a situation of having a longer account payables period but a shorter account receivables period.
I will propose the following measures to help you protect your working capital
- Procure longer credit payment days from your suppliers while you demand shorter debt period from your customers. In practical terms, you may insist on getting 60days -90days credit period from your suppliers while you do not sell on credit and if you must do so, at not more than 30days. By doing this, you not only save the interest cost of working capital but also earn some interest out of investments. Be careful with this though, this short term fund has to be used for a short term investment. Using a short term fund for long term purposes increases the risk of having Current Liabilities that are overdue for settlement as Non-Current Assets can’t be easily converted to cash to meet short term obligations.
- Sell. Sell. You must sell your product or service to expect cash inflows. Pursue selling method that support stronger cash flows
- Always ensure you have a cash budget that defines when you expect inflows and outflows. The budget must also contain triggers that inform you if you are either failing on the cash inflow lines or cash outflows are more than planned for corrective action to be taken.
- Your company must have a culture of saving/investing any surplus so that it can build a cash reserve and also become a source of funds to finance major capital expenditures that must have been planned
- The company must have a strong procurement and debt/credit process to reduce incidences of bad debts
- Access your company working capital situation, note patterns of payment of credits and receipts of inflows from debtors
- Periodically monitor working capital ratios
- Production must be well planned so also in raw materials sourcing.
The effect of Working Capital is felt differently amongst companies depending on what business sector the company is in. A manufacturing company may not feel the same effect of working capital with a retail store. It’s important you understand where your business falls in when trying to conduct a working capital analysis. Manufacturers are probably more subject to working capital challenges than other businesses because supplier and production expenses frequently require payment several months before goods are sold to customers. In fact, Working Capital is ranked as almost top of the list by manufacturers when it comes to business challenges they are faced with. So as a matter of emphasis, I’d just reiterate, it is necessary to understand what business sector you are in in other to effectively conduct a working capital analysis.
How can I analyze my working capital? And where can I check for the impact of working capital level on my business? This is most likely the question on your mind at this stage. Well for the first part of the question, there are several tools that could help you analyze your working capital and even more that’ll help you further explain why X is Y. As a general rule of thumb, it is said that your working capital should be able to cover your Current Liability at least twice for an optimal Working Capital- this is an analytical tool known as Current Ratio. Tools like the Working Capital Cycle will further help you explain why you don’t have sufficient Current Asset to cover your Current Liabilities, it may be that your cash is tied down in inventory or your account receivables are delaying to settle or it could even be that you were not able to negotiate effectively with your suppliers for a favorable payables period. As for where you can check for the impact of Working Capital level on your business, your Cashflow statements is where you should be headed, particularly the Operating Cashflow Statements, this is where you’d witness the effect of an increase or decrease in inventory, an increase or decrease in account receivables and even an increase or decrease in the level of your creditors.
Working Capital is an extremely important concept in business such that if not managed properly could lead a business to bankruptcy even when the business is profitable. It is used to measure managerial effectiveness, thus Working Capital can serve as an indicator of how well a company is operating. When the Working Capital level is high more funds are tied up in daily operations indicating that the company is being too conservative with its finances. Likewise when the working capital level is low less money is devoted to daily operations which signals that the company is being rather aggressive with its finances. More often than not, a company’s working capital is simply a core part of its daily operations and it is particularly important for a business owner to give it all the protection that it requires to avoid the business folding up in no time.
To summarize all that has been said, the dangers of not protecting your Working Capital would be itemized.
- The best case scenario is having so much cash tied up in the business without yielding any investment returns whatsoever.
- It could make a business not able to meet up with liability obligations when they fall due.
- In the long wrong, it’ll create a bad working relationship with your creditors
- It’ll eventually cause a business to finance these debt by entering into unfavorable loan arrangements.
- Finally, an extreme case of not protecting your Working Capital would be Bankruptcy and Insolvency.
To completely guard against these dangers, your best bet would be to engage the services of a Financial Expert who will help stabilize your business Working Capital, manage your funds properly, and with skill and expertise invest your surplus and idle cash.
Otto Ekpe-Juda, ACA.
About the Author
Otto Ekpe-Juda is a Chartered Accountant that loves engaging issues in Finance and Accounting, with specific bias in Audit, Forensic Accounting, Tax, SME Advisory, Accounting Advisory, Business Valuation, Insolvency & Corporate Re-engineering and Mergers & Acquisition