Working capital represents the net current assets available for day-to-day operating activities. It is defined as current assets less current liabilities. The components are usually inventory and trade receivables, trade payables and bank overdraft.
Many businesses that appear profitable are forced to cease trading due to an inability to meet short-term obligations when they fall due. Successful management of working capital is essential to remaining in business.
Working capital management requires great care due to potential interactions between its components. For example, extending the credit period offered to customers can lead to additional sales. However, the company’s cash position will fall due to the longer wait for customers to pay, potentially leading to the need for a bank overdraft. Interest on the overdraft may even exceed the profit arising from the additional sales, particularly if there is also an increase in the incidence of bad debts.
Working capital management is central to the effective management of a business because:
- current assets comprise the majority of the total assets of some companies
- shareholder wealth is more closely related to cash generation than accounting profits
- failure to control working capital, and hence to manage liquidity, is a major cause of corporate collapse
One of the two key objectives of working capital management is to ensure liquidity. A business with insufficient working capital will be unable to meet obligations as they fall due, leading to late payments to employees, suppliers and other providers of credit. Late payments can result in lost employee loyalty, lost supplier discounts and a damaged credit rating. Non-payment (default) can lead to the compulsory liquidation of assets to repay creditors.
The other key objective is profitability. Funds tied up in working capital tend to earn little, or no, return. Hence, a company with a high level of working capital may fail to achieve the return on capital employed (Operating profit ÷ (Total equity and long-term liabilities)) expected by its investors.
Therefore, when determining the appropriate level of working capital there is a trade-off between liquidity and profitability: