III.2. The role of working capital
A business will incur expenditure in undertaking production
before recovering thisplus, it will hope, a surplus representing
profitin sales revenue. Overhead expenses also have to be paid. Working
capital is the finance available to a business to meet its day to day
operational costs in pursuit of profitable activity.
(i) Cash
Wages, supplies of materials and other items, money owed to the
bank; all these must be paid eventually in cash. Neither suppliers nor the bank
manager are going to accept a delivery of stock as an alternative. Cash is
needed for settling liabilities when these become due.
Whilst it may feel comforting to have lots of cash, a business
exists in order to produce and sell profitably. It needs sufficient cash to meet
its immediate obligations, but no more. Profits ensue from investment of cash in
other assets: the stock which will be sold, materials and tools to produce it,
providing credit to customers who will buy it.
Keeping cash in a tin or non-interest paying bank accounts bears
a cost. Investment in the operations of a profitable enterprise will yield a
return, which, expressed as a percentage, is known as the return on capital
employed. If available cash is surplus to internal requirements, it can be
invested outside for whatever interest rate is available. Cash can pay off
interest-bearing liabilities. The cost of cash sitting still is equivalent to
the interest paid on borrowing or the interest lost by not investing it.
(ii) Debtors
In most businesses, it is necessary to sell on credit in order
to obtain sales. Obviously, debtors are not such an attractive asset as cash;
they can perhaps be fairly described as a necessary evil. In the first place,
there is a time delay before the cash is received, and this bears a cost
equivalent to that of idle cash. Second, there is a risk factor; some debtors
might not pay. Most businesses suffer the occasional bad debt.
Normally, a business balances the cost of debtors by itself
taking credit from its suppliers. It is clearly helpful if the amount of debtors
does not exceed the amount of creditors. Where it does, there is a net cost in
financing trade credit.
In a buyer's market, customers will sometimes demand that items
are supplied on a consignment basis. This is much less favourable to a business
than a definite sale on credit, because of the additional risk that a percentage
of the goods might be returned. Sometimes goods returned are not in perfect
condition either, and have to be sold at a reduced price. No effort should be
spared to minimize the amount that is sold on consignment.
(iii) Stock
The stock levels required by a business will tend to depend on
its sales policy. If it sells to the consumer directly, it will need to hold
higher stocks than for wholesale or export trade. Again, wholesaling to the
domestic market requires a higher stockholding than exporting, where production
usually commences only against firm orders. A business holds stocks primarily
for the purpose of obtaining sales. An order can be lost if stocks are not
available for immediate delivery. Stocks can be needed to overcome seasonality
of trade, where peak demand exceeds production capacity and can be met only by
stocking up beforehand. Raw materials sometimes need to be stock-piled because
they are only available at certain times of the year. This can be true
especially of plant fibres.
Stock might also be held with a view to increasing
profitability. Materials might be cheaper at certain times of the year, or if
bought in bulk (see Figure 4). A price increase might be known to be in the
pipeline. It is sometimes possiblethough unusual in handicraftsto
obtain efficiencies in large production runs beyond orders on hand.
Holding stock bears the same cost to a business as holding cash,
or financing debtors; but probably others besides. There might be storage
charges, and insurance premiums. Moreover, holding stock risks obsolescence,
whereby it loses value as customer taste changes. There could be a risk of
damage, perhaps by climatic conditionsmoisture might cause concern to the
Fibre Mat Society or maybe infestation.
Producing stock just because there are no orders on hand, and
because the artisans need to be kept busy, could be an expensive undertaking.
The objective of stock management is to hold enough to maximize sales, but no
more.
(iv) Creditors
To delay the payment of its bills means that the business can
use the cash to finance assets. If creditors do not levy an interest charge, or
offer discounts for prompt settlement, then it is definitely worthwhile to use
their money for as long as possible.
However, delaying payments can have an unfavorable A business
might find difficulty in obtaining its supplies if it gains a reputation as a
slow payer. It might have its credit facility removed altogether, forcing it to
purchase in cash. Judgement about how much credit to take, and for what period,
must take account of the effects on supplies essential to production and hence
to profitability.
Deferring payment of wages might also be inexpedient, as well as
causing hardship to the artisans and staff. Skilled people might leave as a
result.
(v) External borrowing
A small new enterprise, or one with a poor profitability
performance, might find it difficult, or even impossible, to borrow money
externally. It would be obliged to survive on those financial resources it could
generate internally. Even if a business does not have an overdraft facility, or
access to loan finance, this will inevitably bear an interest cost.
Internally-generated finance is a preferable option, and sometimes the only one.
However, in recent years, many social production units have been
able to obtain very cheap, or even free, external finance. There are two
sources: government, introducing schemes to stimulate employment-generation in
the small-scale sector; and voluntary agencies, giving interest-free loans for
the same purpose. Where such external finance is available it clearly makes
sense to take maximum advantage.
Moreover, it would be quite wrong to discourage the idea of
external borrowing in general. Significant growthnecessitating higher
levels of stocks and debtors, and probably promotional costsor the
purchase of fixed assets, would usually require the use of external funds. If
the rate of interest paid by an enterprise is less than its return on capital
employed, then borrowing is
worthwhile.