To understand what working capital is, we first need a definition of what capital is. All businesses need capital to get started and to grow and, of course, some need more than others.
Capital can come from two sources;
- Firstly, business owners can put their own cash into a business
- Secondly, the business can retain some of the profit it makes each year to help fund its own growth in the next financial period.
Here’s a key point to remember; in our world, “capital” and “equity” are just different words to describe what are basically the same thing. They both indicate that funds have been contributed to the business by the owner or owners.
To really understand the concept of working capital we have to revisit the account equation which is, if you recall; assets equals equity plus liabilities. So, from that it’s obvious that any additional equity from either of the two sources can be used to either reduce the liabilities of the business or to increase the assets or, perhaps, a combination of the two.
If the equity is invested into assets, there are only two types of assets that it can go into. It can be used to increase non-current assets such as property, plant and equipment or to increase current assets such as inventory and accounts receivable. It’s the current assets that represent the working capital of the business.
So equity that is used in that way is being invested in assets that generate cash flow and profit for the business which is why working capital is important to lenders – it’s made up of the assets that create the business’ cash flow and, as we all know, it’s cash flow that repays debt.
To finish this introduction, let’s take a brief look at the working capital cycle – it indicates the speed and strength of the business’ cash flow.
The business begins the cycle with cash and it purchases inventory. It can use cash for the purchase or, of course, there is also an option to obtain it from suppliers using trade credit terms instead of using cash. The inventory is then sold to customers on credit terms at which point they become accounts receivable. At some time in the near future these accounts receivable are collected and so the cash returns to the business. With the cash, the business can pay its operating expenses and creditors and then buy more inventory to start the cycle over.
The big challenge for the business is to keep that cycle turning as quickly as possible to make sure that there is cash available when required to pay its operating expenses and creditors as needed.