Make or Break

Managing working capital is a critical component of financial management. It can make or break a company.

Inadequate working capital can put a company in jeopardy rather quickly due to liquidity problems. On the other hand, excessive working capital strains the company’s finances.

Accounting Definition

Accounting defines working capital as Current Assets less Current Liabilities. It is also known as Net Current Assets. Current assets are those which are considered liquid and are convertible or expected to be realizable in cash within a period of 12 months from the date of the financial report. Common examples include cash, inventories, accounts receivables, prepayments and marketable securities. Current liabilities are those which are expected to be repaid within a period of 12 months. Examples include bank overdraft, short term borrowings, accounts payables and accrued expenses.

Operating Standpoint

Operationally, working capital indicates the ability of the company to finance its current operations and to meet obligations when they mature. It measures the company’s ability to pay daily bills from a liquidity
standpoint.

When it is Inadequate

If there were more current liabilities than current assets, the result is called Net Current Liabilities, Working Capital Deficit or simply Negative Working Capital.

If all the liabilities were to become due and payable immediately, the company does not have sufficient liquid resources to pay them. This could potentially lead to a going concern problem, which means that the company may not have the ability to continue in operations if it could not successfully find sufficient liquid resources to settle its obligations quickly.

From a financial ratio perspective, a company’s working capital position is also represented by its current ratio. Current ratio is calculated using current assets to divide by current liabilities. A current ratio of
less than one means that working capital is negative. For example, if current assets were $100 and current liabilities were $120, the working capital deficit calculated would be ($20). The current ratio is computed as 100/120, giving 0.83, which is less than one.

Remedial Strategies:

To relieve working capital deficit, the following strategies are commonly adopted:

a. Raise Equity

A company can issue more shares to existing or new investors to bring in fresh funds. This infusion of equity will help to raise cash. The side effect of this may be to dilute the interest of existing shareholders who do not wish to inject further equity into the company.

b. Selling Non-current Assets

Non-current assets are those which are not expected to be convertible into cash within a period of 12 months from the financial report date. These are typically fixed assets such as property, plant and equipment. Included
here are also long term investments in other companies. A company can sell its non-core assets to raise cash to enhance its working capital position.

The other way of liquefying its balance sheet may be to enter into a sales and leaseback transaction of its property. This would result in cash infusion into the company.

Ceasing further capital expenditure would be wise till the cash situation and working capital position improve.

When Having Too Much is Bad

On the other hand, having too much working capital may not be ideal either. This is particularly so if the expansion of working capital is due to the rise in inventories and trade debtors, especially when they are
rising faster than sales revenue.

Inventories

Excess inventories pose several problems for businesses. The first is that of obsolescence risk. It could mean physical deterioration as well as technical or market obsolescence.

The second problem is that inventories drain cash. Liquid cash is tied up until the products are sold and the money collected from customers.

The third problem is that inventories require storage facilities. This takes up valuable space and may cost a business in terms of rental expense or opportunity cost in terms of facilities tied up.

If a business has old inventories, it would be advisable to clear them out quickly and free up the cash so that it can be redeployed for better uses.

Trade Debtors

Trade debtors represent financing by the company to its customers. Most often, this is interest and collateral free. On the other hand, the company may need to obtain bank financing on which it incurs interest.

When trade debtors build up, it may also be an indication of lax credit policy and poor follow up on outstanding debts. It may be worthwhile to engage additional resources to recover these receivables more quickly than letting customers take their time to settle their invoices way beyond the credit limit given.

It Boils Down to Efficiency

The more efficient a business can manage its inventories and trade debtors, the better it is for liquidity. More cash would then be available for growing the business, reducing finance costs and paying shareholders
dividends.

Conclusion

As we can see, it takes prudent financial policies, management discipline and vigilant monitoring to ensure that a fine balance is maintained for working capital. But the effort will pay off handsomely for the business
with the will to do so.

Author Bio: James Leong is the MD and principal consultant of VisionsOne Consulting Pte Ltd. James can be reached at jamesleong@ visions1.com.sg or www.visions1.com.sg. Catch James in action on YouTube under: “jamesleongtraining”.

Category: Finances
Keywords: financial management, working capital