Revise Working capital for Cambridge 9609 (5.1.2)

Working capital is the finance available for the day-to-day running of a business. It represents the firm's ability to meet its short-term financial obligations. Calculated as Current Assets minus Current Liabilities, it provides a snapshot of a company's operational liquidity. Current assets are resources expected to be converted into cash within one year, such as inventories, trade receivables, and cash itself. Current liabilities are debts due for payment within one year, including trade payables and bank overdrafts. A positive working capital figure is generally desirable, indicating that a business has sufficient short-term assets to cover its short-term debts. This fund is crucial for financing the operational cycle of a business, from purchasing raw materials to receiving payment from customers.

The working capital cycle, or cash conversion cycle, is the time it takes for a business to convert its net working capital (inventories and receivables) into cash. The cycle begins with paying cash for raw materials and ends with receiving cash from the sale of finished goods. A shorter cycle is preferable as it means cash is tied up for less time, improving liquidity. The length of the cycle is determined by three factors: how long inventory is held, the time taken to collect payment from trade receivables, and the credit period received from trade payables. Effective management aims to minimise the duration of this cycle without damaging customer relations or production processes, thereby freeing up cash for other purposes like investment or debt reduction.

Effective working capital management involves balancing the components to optimise liquidity and profitability. Managing inventories might involve using Just-in-Time (JIT) systems to reduce holding costs, but this increases reliance on suppliers. For trade receivables, management involves setting appropriate credit terms and implementing robust credit control procedures, such as offering discounts for early payment or chasing overdue debts, to speed up cash inflows. Conversely, a business may seek to extend the credit period with its trade payables, effectively using suppliers' money as a short-term source of finance. However, this must be balanced against maintaining good supplier relationships and avoiding late payment penalties. Each decision involves a trade-off between risk, cost, and operational smoothness.

There is a critical trade-off between liquidity and profitability in working capital management. Holding high levels of working capital (e.g., large inventory stocks and generous credit to customers) enhances liquidity and reduces the risk of being unable to meet short-term debts. However, these assets generate little to no return, creating an opportunity cost and reducing profitability. Conversely, minimising working capital (e.g., using JIT and tight credit control) frees up cash for more profitable investments but increases the risk of illiquidity and operational disruptions. A business that expands sales too rapidly without sufficient working capital to support the increased level of production and credit sales is said to be 'overtrading', which can paradoxically lead to business failure despite rising profits.

Working capital = Current assets − Current liabilities

Current ratio (related) = Current assets ÷ Current liabilities