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:
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.
A more stringent test that indicates whether a firm has enough cash to cover its immediate liabilities is the acid test or quick ratio. The acid test is conducted by dividing the current assets minus inventory by current liabilities minus bank overdraft. The logic behind this calculation is that inventory can at times, be relatively difficult to convert to cash. A firm may have a good current ratio, but a poor quick ratio. There have been occasions in the past where a businesses current ratio has been well above 1 and they have still run into trouble. When the same business has been subjected to the acid test, a number substantially below 1 has been revealed. A quick ratio below 1 indicates that a firm is not be able to meet its short term debts.
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.
The following points illustrate some important features of the cash conversion cycle:
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.
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:
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.