III.1. Defining working capital

The balance sheet of a business shows its overall financial position at a particular point in time. Specifically, it records three things:

Assets: what the business owns, and has value

Liabilities: what it owes to other parties

Capital: the value of the proprietor's stake.

(i) Assests and liabilities

A separation is made in the balance sheet between those assets and liabilities which are part of the permanent structure of the business, and those which rather represent its day to day operations.

Assets: Fixed assets, deemed to be retained in ownership for a long period—e.g. land, buildings, machinery, equipment, vehicles—are separated from other assets which are owned for short-term purposes, such as stock.

Liabilities: Long-term liabilities, i.e. those not needing to be paid for perhaps one year or more, and the capital of the business, are separated from short-term liabilities, i.e. those needing to be paid in, say, 3-6 months, but definitely less than one year.

Working capital is concerned only with short-term assets and liabilities, called current assets and current liabilities. By current assets is meant assets which can be converted into cash in the short-term future. Similarly, current liabilities are liabilities which must be paid in cash in the short-term future. Working capital can be defined as the net difference between the current assets and current liabilities.

The term working capital is sometimes used erroneously as a synonym for cash. It does mean cash, but it means more than that. From the above, it follows that it means the difference between cash on hand, plus assets which can be converted quickly into cash, and liabilities which must be settled quickly in cash.

(ii) Components of working capital

Consider the balance sheet of a handicrafts production unit (Figure 8). It can be seen that the components of working capital are as follows:

Assets:
Cash—on hand and in the bank
Debtors—(also called accounts receivable)—money owed to the business
Stock—of raw materials and partly and fully finished products
Liabilities:

Deferred wages—money due to people within the business Creditors—money owed to outside parties

Advance payments—money received in advance for products still to be supplied

Overdraft or loan—money borrowed from the bank, due for repayment in the short term.

Figure 8. Fibre Mat Society—Balance Sheet at 30 September 1986

Assets
Current assets

Liabilities
Current liabilities

Working capital takes account of all current assets and liabilities, not just the cash. It is not concerned with fixed assets or long-term liabilities because these are not held with a view to conversion into cash.