1 – Working Capital is Not Cash!
First and foremost, let’s be clear what working capital is not, it’s not cash! In fact, all things being equal, when working capital goes up, cash goes down, and vice versa. You'll often hear the expression, "the business needs to fund working capital for growth", when what is actually meant is that the business needs extra cash to finance the increase in working capital that accompanies growth. Businesses that try to grow without sufficient working capital are said to be 'over-trading'.
In most businesses, the basic components of working capital are stock, plus trade debtors, minus trade creditors. This working capital will have built up over time as the business has grown and, generally speaking, the longer a business has been trading, the more complex the components of working capital will have become. To explain this, we can consider a company that starts trading on Day One, wholly in cash and without holding any stock. After its first year of trading, all profits will be in the form of cash, so its balance sheet will be 100% cash, and there will be no working capital – i.e., no stock, debtors, or creditors. However, as the business starts to give credit to its customers (that become trade debtors), take credit from its suppliers (that become trade creditors), and invest in the stock, the constitution of the balance sheet will change such that its assets are cash, trade debtors and stock, and its liabilities are its trade creditors.READ MORE >>