Working capital

The essentials

Working capital is the money needed to run the day-to-day operations of a business, such as buying raw materials, paying wages and giving credit to customers. It is tied up in current assets.

• Gross working capital = total current assets.
• Net working capital = current assets − current liabilities.
• Current assets: cash, bank balance, inventory (stock), debtors (trade receivables), bills receivable, short-term investments, prepaid expenses.
• Current liabilities: creditors (trade payables), bills payable, outstanding expenses, short-term loans, bank overdraft.

Key points

• Operating cycle: the time taken to convert cash into raw materials, then into finished goods, then into sales and debtors, and back into cash.
• Net operating cycle (days) = raw material holding period + work-in-progress period + finished goods holding period + debtors collection period − creditors payment period. (Before deducting the creditors payment period, the total is the gross operating cycle.)
• Working capital requirement ≈ cash cost of operations per day × operating cycle in days, often plus a safety margin.
• Factors increasing working capital needs: longer production process, seasonal business, liberal credit to customers, rapid growth, rising prices.
• Factors reducing needs: quick stock turnover, cash sales, credit received from suppliers.
• Current ratio = current assets ÷ current liabilities.

Exam tips

• Remember that credit from suppliers is subtracted in the operating cycle because it delays payment.
• Machinery, land and buildings are fixed assets, not part of working capital.

Common mistakes

• Adding the creditors' period instead of subtracting it.
• Treating a long-term loan as a current liability.