working capital

110. Working Capital – what is it and why it is so important to tame it

If I said that working capital is (or should be) a key management tool then I would probably get some pretty strange looks.

But I would then go further and say that:

Managing working capital should be one of the key responsibilities of your CFO or FD as it is a really accurate barometer for assessing the short and medium term health of a business.

This article sets out the basics you need to know – it will help you understand what it is and why it is so important.

What is working capital?

According to the text books, it is the figure showing the difference between current assets and current liabilities. In practical terms, it is the cash you will have left after accounting for the money coming in to, and going out of, your business over the next 12 months.

Bear with us; you are going to have to dig out a recent balance sheet – you do have one don’t you? – as your profit and loss account will not help you here.


Working Capital = Current Assets (‘CA’s – that is stocks, debtors and cash) MINUS Current Liabilities (‘CL’s – eg suppliers, taxes, short term loans).

Current’ by accepted practice is receivable or payable within 12 months.

Working Capital shows how efficient the business is and provides a snapshot of its resilience.

Which means that proactive working capital management really must be one of your top priorities if you are not already doing it.

It is not the same as cash flow – Cash flow and working capital may seem the same but you must not mix them up. Your cash flow statement tells you what is happening to cash – how much is coming in and going out and when, together with the cash balance. It does not show you how much wriggle room you might have if things do not go so well.

You can finesse this by dividing CAs by CLs to give you the Working Capital Ratio (sometimes referred to as the Current Ratio).

Current ratio – what sort of number should you aim for?

The aim is to always have “good” liquidity which means you are well placed to react and take advantage of short term opportunities and manage through the bad times.

You are looking at an absolute ratio – above 1.0 sounds good but too high or too low a ratio may highlight problems down the track.

If it is too low (below 1.0) – you need to urgently look at operations, your pricing strategy and management and funding of liabilities.

If it is high (above 2.0 and not due to high cash balances) then this may indicate that:

  • stock is stacking up
  • you are inefficient collecting your debts
  • you are paying your suppliers earlier than you need to

How to address a poor ratio

Review the financial projections for the business, by:

  • Reviewing cash projections to check that liabilities are funded by projected receipts or existing (or planned) sources of finance
  • Confirming the valuation and recoverability of your stock and debtors

What should you do if you have surplus cash?

If you are in this position then you need to have a strategy to make this cash work for you. The sort of levers you can pull include:

  • Paying for stock upfront and getting discounted prices
  • Buy more stock at one time to generate volume discounts
  • Use the cash as a buffer to bridge cash flow holes
  • Embark on a marketing campaign to deliver high margin sales
  • Pay suppliers on time to ensure you get the best possible service (and price)

Look at the change in working capital – both in the absolute and the ratio – over time to give you a trend.

Creditor Strain – This is one thing that is often overlooked. Creditor Strain is defined as the “unauthorised extra credit taken from suppliers”. When cash is tight, businesses often lean on their creditors (here read suppliers) by delaying payment to them. You can play this game for quite some time within reason; but it is risky and at some point you will have strained your suppliers too much. Remember, it just takes one supplier to have had enough to bring the company down. Creditor Strain attempts to measure how close you are to that point.

To manage working capital properly you will need robust and accurate forecasts of activity – meaning not just a profit and loss account; but also a cashflow forecast and balance sheets which all link together. Tectona can quickly provide this for you by running you through our Quad² Review.

Having identified that you do need funding and how much we can then help you review the funding options available to you.

Contact the Tectona team so that we can talk you through your options.

About Tectona

Tectona Partnership helps business owners sleep at night by embedding one of our 15 commercial finance directors in your management team. Very often, a part time solution is usually the most effective for small businesses. We make sure you have the necessary management information and strategic insight to make informed decisions and will tell you what you need to know, when you need to know it.

Posted in Tectona Ten - Managing Cash, Business Development and tagged , .