Working capital — common mistakes

In exam questions, be prepared to analyse the consequences of having too much or too little working capital. Use the concepts of liquidity, profitability, and opportunity cost to structure your answer. For example, explain that while low inventory reduces holding costs (improving profit), it risks stock-outs and lost sales.

Not necessarily. While a high level of working capital ensures liquidity and reduces risk, it can be inefficient. Excessive funds tied up in inventories or receivables have an opportunity cost – that money could be invested elsewhere in the business to generate higher returns, thus improving profitability. The goal is to have an optimal, not maximal, level of working capital.

No, they are different. Cash is just one component of working capital. Working capital is the net value of all current assets (cash, inventories, trade receivables) minus all current liabilities (trade payables, overdrafts). A business can have positive working capital but very little cash if its current assets are mostly tied up in inventory and receivables that are slow to convert into cash.

Yes, absolutely. This is a crucial concept. Profit is an accounting measure (Revenue - Costs), often including credit sales not yet paid for. A business can report high profits but have all its cash tied up in inventories and receivables, while bills from suppliers (payables) are due. This lack of cash, or illiquidity, means it cannot pay its debts, potentially leading to insolvency and failure. This is often summarised as 'cash is king'.