Last edited 03 Mar 2016

Working capital


[edit] Introduction

The term ‘working capital’ refers to the operating liquidity of a company or organisation, that is, its current assets (such as stocks, trade debtors, plant, cash and so on), minus its current liabilities (such as trade creditors).

Working capital represents a net investment in short-term assets. These assets are continuously flowing in and out of the business and are essential for day-to-day operations. The needs for working capital is likely to change over time due to changes in interest rates, market demand, the state of the economy, production methods, and so on.

[edit] Management of stocks

A company may hold stocks for a number of reasons, most usually to meet immediate day-to-day requirements of clients and production. They may choose to stockpile if it is believed that future supplies or work may be interrupted, may be scarce or may rise in cost. Stock management may react to variations over the course of year, particularly in seasonal industries.

It may be important to minimise the amount of stock held, perhaps due to the significant costs associated with holding stocks such as storage, handling, financing, etc. However, costs may also be associated with a low stock level, such as loss of sales, loss of client goodwill, inefficient production, purchasing stocks at higher prices, and so on.

To try and ensure there will be stock available to meet future business needs, a company must produce appropriate forecasts of demand, but due to uncertainties, a buffer/safety stock level may also need to be maintained. The ‘economic order quantity’ (EOQ) is the optimum size of a purchase, taking account of both the cost of holding stocks and the cost of ordering stocks.

[edit] Management of debtors

There are certain costs incurred by selling goods/service on credit:

  • Credit administration costs.
  • Bad debts.
  • Opportunities foregone in using the funds elsewhere.

However, there are benefits of selling goods/service on credit, such as the increased sales resulting from the opportunity for clients to delay payment.

When considering a proposal from a client applying for credit it is important to remember the ‘5 C’s of credit’:

  • Capital (the customer be financially sound – profitability, liquidity, etc.)
  • Capacity (they must have the capacity to pay amounts owing)
  • Collateral (there must be security for goods supplied on credit)
  • Conditions (the state of the industry/economy in which the customer operates)
  • Character (willingness to pay, reputation)

Sources of information available for assessments include:

  • Trade references.
  • Bank references.
  • Published accounts.
  • The customer (i.e. interview directors).
  • Credit agencies.

A company may decide to offer a cash discount in an attempt to encourage prompt payment from its credit clients. The size of any discount will be an important influence on whether a client decides to pay promptly. From the point-of-view of the company, the cost of offering discounts must be weighed against the likely benefits in the form of a reduction in the cost of financing debtors and any reduction in the amount of bad debts.

A company offering credit must ensure that the amounts owed are collected as quickly as possible, through invoices and reminders. The cost of ‘bad debts’ (clients who cannot pay) should be taken into account when pricing products or services.

It is common for companies to use ageing schedules that divide debts into categories according to the length of time the debt has been outstanding

[edit] Management of cash

Generally, there are three motives for a company to hold cash:

[edit] Transactionary motive

To meet day-to-day commitments, wage payments, overhead expenses, goods purchased, and so on.

[edit] Precautionary motive

If future cash flows are uncertain it can be prudent for a company to hold a balance of cash.

[edit] Speculative motive

To be in position to exploit profitable opportunities as and when they arise, such as the acquisition of subcontractors.

If a company can borrow quickly then the amount of cash on hold can be reduced. If the company holds assets that can easily be converted to cash then the amount of cash that is held can be reduced.

[edit] Management of trade creditors

Clients who pay on credit may not be as well-favoured as those who pay immediately. They may, for instance, receive lower priority when allocating the stock available, or may have to incur additional admin and accounting costs. However, provided that trade credit is not abused by a company, it can represent a form of interest-free loan. It can also be a much more convenient method of paying for goods and services than paying by cash.

[edit] Find out more

[edit] Related articles on Designing Buildings Wiki

[edit] External references

  • ‘Construction Economics: An Introduction’, GRUNEBERG, S., Palgrave (1997)