In our introduction to working capital post, we defined working capital as the amount of equity that is invested in current assets such as stock (inventory), trade debtors (accounts receivable) or left as cash in the bank account.
A problem occurs when the business holds an excessive amount of working capital. To understand why that is we need to revisit the accounting equation. Remember that the equation is;
Assets = Equity plus Liabilities
So that means that the more assets the business has (the left side of the equation), the more funding (right side of the equation) that’s needed because the equation must always be in balance. The problem is that additional funding incurs cost and increases risk.
Effective working capital management is all about investing as little as possible in those current assets without negatively affecting the business’ operations so as to minimise the amount of funding required.
One indicator of good working capital management is that trade debtors (accounts receivable) are collected before trade creditors (accounts payable) have to be paid. That way the business is not having to borrow from the bank or use its own cash to make payments to trade creditors and others while waiting for trade debtors to pay. The only proviso to this is that the trade creditors’ credit terms must not be abused as that could result in interrupted supplies. The trick is for the business to negotiate longer terms with trade creditors and offer shorter terms to its own customers (if it can).
One final point; you often hear the term, net working capital – don’t confuse it with working capital even though the phrases are used interchangeably as though they are the same thing.
Working capital is the total of current assets but net working capital is the difference between the current assets total and the current liabilities total. When net working capital exists, a good question to ask yourself is how the business funds it since the short-term liabilities have already been accounted for to arrive at the net working capital figure. In that case, the only means of funding are equity and long-term (or non-current) liabilities.