Well managed businesses understand and actively manage their working capital. Mismanagement of working capital can lead to business failure despite the business producing profits on paper. It is sometimes said, more businesses fail for lack of cash than want to profit.

What is Working Capital?

Working capital is defined as current assets minus current liabilities. Working capital is needed for the following purposes:

• To provide for the day to day outgoings of the business such as inventory, wages and other payables.
• As a precaution against unexpected emergencies, for example a temporary downturn in trade in which the business has more cash outflows than cash inflows.
• To fund potential opportunities that present and need to be taken advantage of rapidly. For example if a supplier offers a large discount on a certain item which needs to be purchased immediately.
• For small to medium capital investment and purchases. These may be in the form of minor renovations to facilities or purchases of equipment, furniture, fixtures or machinery.

At any given time, the level of working capital within a business can be either positive or negative. If a particular business has a higher level of current liabilities than current assets, that business will have negative working capital. A negative working capital position is an indication that the organisation may find it difficult to meet its short term debts. In extreme situations, a business may simply run out of cash and fail.

Working Capital Adequacy

A common way of assessing the level of working capital within a business is to use the current ratio. The current ratio divides current assets by current liabilities. The result can give an indication of how adequate the level of working capital is within an organisation. A number above 2 suggests the organisation has a healthy working capital position, a number lower than 1 indicates a negative working capital position, a position which is unsustainable.

An organisation in trouble

Organisations develop working capital problems for a variety of reasons. Some of these include trade downturns, rapid business growth and failure to manage cashflow properly. The table below is an example of a business that has gradually developed a working capital problem. Note that both the current ratio and the quick ratio indicate a declining working capital position.

Cash conversion cycle

So how can a business go broke if it is recording operating profits? Put simply, an extended period of time can elapse between when a business uses cash to purchase inventory, pay staff and buy equipment and when a business finally receives payment for delivery of goods and services. This can also be exacerbated by delays between delivery of goods and services to customers and payment being received for those goods or services.  So even if there are plenty of revenues being generated, a company that can't convert sales into cash quickly, may find itself in trouble.

The diagram below indicates a typical business cash conversion cycle.

• If a business sells inventory faster or has less inventory in stock, it will free up more cash. Alternatively if a business increases its holding of inventories and or sells inventory at a slower pace, the business will soak up more cash.
  
• If a business reduces the amount of time between when a sale occurs and when they receive payment, they will increase cash holdings. If a business allows the length of time between when a sale occurs and when they receive payment to increase, cash holdings will decrease.
• If a business negotiates better credit terms with suppliers it will use less cash, if a business pays all suppliers immediately more cash will be used.

The more cash freed within an organisation the less that organisation will have to rely on short term debt finance facilities such as overdrafts or alternatively the business will have more cash with which to reinvest back into its operations.

Cash Holdings:

What is the optimal level of cash holdings? There are two key considerations for businesses when deciding how much cash should be held at a given point in time. These are as follows:

• The costs associated with not having enough cash at a given point in time, for example, if a firm finds itself in need of additional cash it may incur transactions costs, or credit costs if it has to borrow money to fund short term cash requirements.
• If a business holds too much cash, it may be forgoing potential opportunities. That is, the surplus cash could be reinvested back into business operations or the cash could be invested into shares, bonds or other such investments.

So what is the optimal level of cash holdings? Essentially a cash holding that finds a balance between costs incurred as a result of not having enough cash and opportunities forgone as a result of holding too much cash. Most managers determine cash holding needs through planning and experience.