You may not talk about working capital every day , but this accounting term can be the key to your company’s success.
Working capital affects many aspects of your business, from paying your employees and suppliers to keeping your lights on and planning for long-term sustainable growth.
In short, working capital is the money available to meet your current short-term obligations.
To ensure that your working capital works, you’ll need to calculate your current levels, design your future needs, and consider ways to ensure you always have enough money.
This may be a somewhat technical matter, but as a manager, you need to be within that important financial dynamic.
So stay with us and know all about working capital!
What is working capital?
Working Capital (CG) is a financial metric that represents the operational liquidity available to a company, organization or other entity (including government entity).
Together with fixed assets such as plant and equipment, working capital is considered a part of operating capital .
Working capital can be found by the following formula:
CG = AC-PC (Working Capital = Current Assets – Current Liabilities)
The active current (AC) is an accounting term that refers to assets that can be easily converted to cash. For example, money is a current asset, as are most accounts receivable.
Current Liabilities (LPCs) is an accounting term similar to AC. Current liabilities are the value of liabilities that must be settled in cash within one year (or during the company’s operating cycle).
Because it is the difference between the two (AC- PC ), working capital is a measure of liquidity.
It signals whether the company has sufficient assets that can turn into cash to pay future liabilities. However, it is not a perfect sign.
Since most expenses and debts are to be paid in cash, having a positive working capital shows that the company has the ability to pay the expenses and debts that will arise or will expire in the short term.
Working capital, however, does not guarantee that a company can pay off all short-term expenses or obligations.
See the following working capital example :
Suppose a company has current assets of R $ 100,000.00: R $ 20,000.00 in cash and R $ 80,000.00 in accounts receivable.
The company also has R $ 50,000.00 of current liabilities .
This means that the company has a working capital of R $ 50,000.00.
One of your accounts payable expires tomorrow, so the company must R $ 40,000.00 and have R $ 20,000.00 in cash, but can not receive the other R $ 20,000.00 until tomorrow.
The company can not pay a short-term expense, although a positive current liabilities say that the company should be able to pay most of the expenses and loans in the short term.
The amount of Working Capital does not guarantee that the company will have sufficient cash for each expense , only indicates that it has operational liquidity.
Controlling working capital components
Working capital (CG) can be controlled by changing the levels of current assets and / or current liabilities through various mechanisms.
Each company has different demands on how much working capital (CG) needs, but all companies prefer to have positive working capital (remember that CG = AC – PC).
Having a very small CG impairs a company’s ability to meet its financial obligations.
It is difficult to pay expenses or debts that mature in the short term .
Having too much CG can also be bad because it means there are assets that are not being invested.
Holding many short-term assets slows down the future growth of the company. Thus, managing CG to an acceptable level is one of the most important jobs of management.
Working capital can be adjusted by increasing or decreasing its two components: the active current (AC) and current liabilities (PC).
Raising the AC or lowering the PC increases working capital, and vice versa.
Management can approve a number of policies for GC management, some of which are highlighted below:
- Cash Management : Identify the cash balance that allows the company to meet daily expenses, but reduce cash maintenance costs. Money is an AC.
- Inventory management : identify the level of inventory that allows uninterrupted production, but reduce investment in raw materials and minimize reordering costs and thus increase cash flow. Inventory is an AC.
- Debt management : identify the appropriate credit policy, such as credit terms, which will attract customers, so that any impact on the cash flow and on the cash conversion cycle is offset by the increase in revenue and, therefore, the return on the capital.
The credit granted to customers (accounts receivable) is an AC.
- Financing management : identify the appropriate source of funding. Short-term financing (as well as long-term financing coming due next year or operating cycle) is a PC.
By tuning these four primary influencers into AC and PC, management can change the CG to a desirable level.
Working capital (CG)
Working capital (CG) is an important metric for all companies , regardless of their size.
CG is a sign of the operational liquidity of a company. Having sufficient CG means that the company must be able to pay all of its expenses and short-term obligations.
Large companies pay attention to current liabilities for the same reason as small ones: working capital is a measure of liquidity and therefore a measure of credibility .
Companies that want to borrow by issuing bonds or buying commercial papers (a market for short-term loans to large companies) will find loans more expensive if they do not have enough working capital .
If the company is publicly traded, the price of its shares may fall if the market does not believe that it has an adequate solvency level.
For small businesses and startups – unable to access financial markets for large loans – the GC has even more important implications.
Working capital can also be described as the amount of money that a small business or startup needs to remain in operation .
Startups need to pay attention to their CG because it represents the amount of money they need to keep the business running to break even (when they start to make a net profit).
On the one hand, CG is important because it is a measure of a company’s ability to pay expenses or short-term debt.
On the other hand, a lot of working capital means that some assets are not being invested in the long term and therefore are not being well leveraged to help the company grow as much as possible .
Working capital is only a measure of the operational liquidity of a company. It is not the only measure , and certainly not a guarantee of a company’s ability to pay.
A company may have CG positive but not have enough money to pay an expense tomorrow. Similarly, a business may have negative CG but may be able to adjust part of its debt in the long run in order to reduce its current liabilities.
CG is an important metric, but it is not the whole story of a company’s financial health.
Understanding Business Needs
Working capital is a financial metric that represents the operational liquidity available to a business.
Considered as a part of operating capital along with fixed assets such as facilities and equipment.
Sufficient working capital is required to ensure that the company can continue operations and that it has sufficient funds to meet short- and long-term debt, and to take care of future operating expenses.
However, excess working capital can lead to a higher cost of capital.
A business can be endowed with assets and profitability but lacking liquidity if its assets can not be readily converted into cash.
Working capital management involves managing inventories, accounts receivable and paying cash.
Calculating working capital
When we calculate working capital, we think in terms of net working capital, which is calculated as current assets (AC) minus current liabilities (CP), as previously pointed out.
This is the value commonly used in valuation techniques , such as discounted cash flows.
If current assets are lower than current liabilities, an entity has a working capital deficiency, also called working capital deficits.
Current assets and current liabilities include three accounts that are of particular importance . These accounts represent the business areas with the most direct impact:
- Accounts receivable (current assets)
- Inventory (current assets)
- Accounts payable (current liabilities)
Ideally, a company wants the accounts receivable to be collected as quickly as possible in order to have the maximum possible use of the funds.
On the other hand, a company strives to postpone the settlement of accounts payable for as long as possible for the same reason.
The current portion of debt is also critical because it represents a short-term claim of current assets and is often secured by long-lived assets.
Common types of short-term debt are bank loans and lines of credit.
Inventory is a special case in which even nonfinancial managers need to stay connected.
Too much stock available will reduce the risk of a company not meeting customer needs, but can also reduce profitability.
An example of reduced profitability would be in the computer industry, where inventories lose value because of the nature of the industry.
Profit and liquidity
In any business, large or small, there is an inherent trade-off between liquidity and profitability.
Large companies have the resources to help them manage this exchange, such as an accounting department, negotiating power with their suppliers or access to the capital market.
For the small entrepreneur , however, who often lacks resources and does not have enough operating history to secure additional credit, managing that exchange may be like walking the tightrope.
Consider the case of a new customer for a small business. This new customer has the potential to deliver tremendous growth in the company’s sales, but this growth in sales will be accompanied by a subsequent growth in variable costs .
The company may not have the resources, ie working capital, to meet those variable costs that come with increasing sales.
Recognize the broader goals of working capital as well as how organizations can consider a long-term perspective when viewing the use of working capital.
Free spin-off money can be used in many ways, when underutilized it incurs the opportunity costs associated with the time value of money, and organizations must use financial planning to ensure the long-term use of this capital.
While short-term planning is predominantly used in relation to working capital (due to the short-term nature of the inputs and outputs involved), it is reasonable to define long-term policies and strategies to incorporate changes in working capital into the financial strategy.
The main benefits of leveraging working capital are liquidity and profitability.
When discussing long-term goals , the focal point is the broader strategy (as opposed to tactics).
From the strategic point of view, there is a certain amount of liquidity that companies would like to keep at any time to ensure they can capture external opportunities in the market.
The availability of working capital easily accessible at all times allows organizations to minimize the cost of lost opportunities and careful regulation of strategic working capital criteria can ensure that the appropriate amount is available.
The other broader objective of working capital is the effectiveness with which it is used over a given period of time .
From a long-term perspective, this profitability metric will be somewhat different from the short-term, that is, working capital returns decisions revolve around how much must be available within any short-term to maximize return (on average) of the existing working capital.
By analyzing the differences in working capital availability over a long period of historical data, the organization can make rough estimates of the ideal amount of working capital availability that allows optimal growth.
Despite the potential advantages of long-term planning in working capital, it is still largely a field of short-term decision-making.
Generally, working capital should be considered within a period of one year or less, making it more often a short-term decision.
Short Term Approach
Working capital decisions are generally short-term , since it is the difference between current assets and current liabilities.
Short-term approach to managing working capital
Working capital is the amount of capital that is readily available to an organization. As a result of the CG calculation, working capital decisions are almost always current, that is, short-term decisions.
In other words, working capital management differs from capital investment decisions – specifically in terms of discount and profitability.
Working capital management applies different criteria in decision making. The main considerations are cash flow / liquidity and profitability / return on capital.
The most commonly used cash flow measure is the net operating cycle or the cash conversion cycle.
This measures how long a company will be deprived of cash if it increases its investment in resources to expand customer sales.
The cash conversion cycle indicates the ability of the company to convert its funds into cash and informs the management of the liquidity risk stemming from the growth .
Since this number effectively corresponds to the time that the company’s cash is tied up in operations and unavailable for other activities, management generally aims to shorten the cash conversion cycle as much as possible.
However, shortening the cycle creates your own risks.
Although a company may even get a negative cash conversion when collecting from customers before paying suppliers, a policy of strict charges and loose payments is not typically sustainable.
The purpose of the study and calculation of the cash conversion cycle is to change the policies relating to the purchase and sale of credit.
A company can change its payment patterns on purchases on credit and receive payment of debtors based on the cash conversion cycle.
If the company is in an effective cash position , it may maintain its previous credit policies.
As we follow in this article, working capital (CG) is the product of the subtraction between current assets and current liabilities .
Companies wish to have a positive GC because it represents an indication that the company has enough assets to turn into money by paying off future expenses or debts.
The CG is a measure of liquidity and is not a guarantee that a company can pay for its liabilities.
And remember: high working capital is not always good . It may indicate that the company has too much stock or is not investing its excess cash.
Now that you know better how working capital works, you can better manage your business.