Cover Image
close this bookFinancial Management of a Small Handicraft Business (Oxfam, 1988, 43 p.)
close this folderIII. The concept of working capital
View the documentIII.1. Defining working capital
View the documentIII.2. The role of working capital
View the documentIII.3. Performance measurement
View the documentIII.4. Profits

III.2. The role of working capital

A business will incur expenditure in undertaking production before recovering this—plus, it will hope, a surplus representing profit—in 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 possible—though unusual in handicrafts—to 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 conditions—moisture 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 growth—necessitating higher levels of stocks and debtors, and probably promotional costs—or 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.