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The importance of working capital

Why timing of money in and out is critical.
Written by Max Valentine
Updated 1 year ago

The inability to pay creditors (suppliers) is one of the most common reasons for business failure.

When you get into the depths of the numbers, you will see references to Working Capital, a number that can fluctuate wildly form week to week.  Accounting speak is that Working capital is the difference between current assets (stock, debtors and cash) and current liabilities (creditors and bank overdrafts).  We say it is the lifeblood of any healthy business, it represents the operating capital, without which no business can survive.

Managing the working capital position is an art - the ability to make cash available when needed and to make the best use of surplus cash when available. If there is to little cash in the business may need to close its doors while too much and it is an indicator of inefficiency.  Managing the Working capital is managing the short term liquidity of the business and the ability to pay expenses and suppliers on time.

So what makes up working capital?
Debtors (those that owe you money) plus Stock less Creditors (those that you owe money to)
The timing of cash payments and receipts is therefore critical to working capital management.  It enables you to understand how cash is tied up in your business and your “Cash conversion cycle” which is the number of days that it takes you to convert what your owed into cash.  You can then compare this to how long it takes to pay creditors.   The longer the working capital cycle of a business, the longer it is tying up cash, i.e. working capital. 

Let’s run through an example, WidgetCo  

WidgetCo sells…widgets…which it buys in from specialist widget suppliers on a strict 30-day credit terms and offers 30-day terms to their customers. All clear so far but the challenge is their customers typically pay only after 35 days, so let’s look at the situation where the company orders £20,000 of widgets which they sell for £25,000 – so what is the position on day 30?

 Amount owed            -£20,000

 Amount received        £0 

 Working capital         -£20,000

WidgetCo must to finance the gap in paying suppliers and being paid and so draw on cash reserves (if available) and pay suppliers or face action.

So if we reverse this where the business has 35 days terms with the supplier and buyers pay within 30 days – at Day 30, the following would be true

Amount owed            -£20,000

Amount received        £25,000

Working capital           £5,000

Here, WidgetCo has enough cash to meet its liabilities when they fall due - a much healthier situation.

Where do you see it in Numberslides?

The drivers of working capital you can see on the balance sheet under the current assets and liabilities.  You can also see the accounts receivable and payable that run through the cashflow.  In Numberslides, we use two inputs to calculate your working capital and this is the days credit that you give buyers and the days credit that your receiving from sellers.  From there, we can work out the rest.

 When working with large businesses, they may be in a position to dictate the terms and it is not unknown to have payment terms from them of up to 90 days!  This is seen as an issue in the economy that really hampers new businesses and SMEs.  This delay in receiving payment has led to companies offering innovative bridge finance called “invoice financing” (also known as “factoring”) where you can received the bulk of invoice straightaway (subject to terms etc) and also the UK government to produce the “Prompt payment Policy" to set a framework to improve the situation for SMEs.

 Investors can focus closely at the working capital cycle because it gives an idea of management’s effectiveness at managing balance sheet assets and generating cash flows. 

Delaying the payment to creditors is a tactic to fund working capital needs but must be done very carefully – essentially you are using creditors funds to finance the business but generally before you do this, you must build a good relationship and trust with your suppliers.  Be wary, in periods of high growth it is all too tempting to maximise your stock to satisfy demand but this must be carefully managed with your cash conversion cycle to ensure no shortfalls.  

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