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.

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.

III.3. Performance measurement

(i) Ratio analysis

The working capital position of an enterprise can be interpreted from a balance sheet by a method known as ratio analysis.

In Figure 8 the current assets of Fibre Mat Society total 90,000. Current liabilities are 70,000. These figures may be expressed as a ratio:

Current ratio = ( Current assets ) / (Current liabilities ) = 90 000 / 70,000 = 1.29:1

The current ratio gives an initial measure of what is called the liquidity of a business. This means the extent to which its current liabilities are covered by cash, or assets able to be converted quickly into cash. It is clear that a current ratio of less than 1:1—meaning that current liabilities exceeded current assets—would be extremely dangerous. Generally, it can be said that an enterprise needs a current ratio of 1.5:1 minimum, and better 2:1. It would appear that the Society has a liquidity problem.

A second working capital ratio looks at the situation a little more critically. This is the quick ratio, or acid test, in which stocks are omitted from the current assets.

Acid test = ( Current assets - stock ) / (Current liabilities ) = 50 000 / 70,000 = 0.71:1

This ratio assumes that if an enterprise had to raise cash very quickly to meet liabilities, it would be able to convert debtors more quickly than stock. The usefulness of the ratio rather depends on the validity of this assumption. For comfort, the acid test should yield a ration of 1:1. The poor ratio of Fibre Mat Society confirms a disturbing situation.

(ii) Limitations of ratios

Like all financial statements, ratios have to be evaluated with care. In the first place, the balance sheet describes the situation at one point in time only, here 30 September 1986. Stocks might be high because the Society is building them up for the peak selling season. A figure which might be unacceptable at one time of year could be less worrying at another.

Apart from the question of seasonality, some standards are required by which to evaluate the situation. The most informative measures are the past financial statements of the business. In comparing what has happened between two balance sheets, it is possible to see if the present situation represents an improvement or a deterioration in performance.

The major shortfall of ratios is that they say nothing about the quality of assets held. Is the stock good, will its value hold, can it be sold quickly? Or does the high figure of finished goods suggest dead stock, overvalued in the books? Are the debtors safe, will they all pay, and when? Further information is also required about the liabilities: What is the Society's overdraft ceiling? How much time will the creditors allow?

In other words, liquidity ratio analysis might signal whether there seems to be a working capital difficulty: but it is only the starting point for looking more closely at the component parts of working capital, for bringing judgement to bear on the true nature and extent of the problem, and for identifying what should be done to improve things.

III.4. Profits

(i) Profit and loss account
In Figure 9 the profit and loss account - otherwise called the income statement - of Fibre Mat Society reveals an enterprise which is trading at a small profit.

Figure 9. Fibre Mat Society - Profit and Loss Account, Year Ended 30 September 1986

Overheads:

This gives us some further information with which to evaluate performance, especially when viewed in connection with the balance sheet (Figure 8). First, it is apparent that stocks have increased by 100% during the year. This could well mean a build-up of slow-moving stock. Without past figures, it is impossible to see sales trends, which might explain a rise in stocks; one would also want to know if any change in sales policy has been made which might necessitate higher stock-holding. Second, we can now see debtor and stock figures in relation to sales. This allows for further ratio analysis to be made. The rate at which debtors are settling their accounts may be calculated by the debtors turnover ratio:

Debtors turnover = ( Sales ) / (Debtors ) = 140,000 / 45,000 = 3.11

This is then expressed in terms of average collection period of debts by dividing the ratio into 365:

Average collection period = 365 / 3.11 = 117 days

This would be a very unsatisfactory state of affairs and an indication of bad debtor management. It might actually be worse than it appears. If a proportion of the sales were for cash then the sales on credit would be less than 140,000 and the average collection period correspondingly larger. The ratio tends to confirm the earlier conclusion stock. Most likely this Society has a product range of declining appeal. Not only are stocks building up in the Society, but also they are not being sold easily by the customers, hence payments are being delayed.

As with the debtors turnover ratio, this can be expressed in a more meaningful way as a number of days stock held:

Days stock held = 365 / 2.8 = 130 days

Had we made the calculation using the beginning of year stock figure or the average—i.e. 30,000—clearly the turnover ratio would look healthier.

Creditors may be looked at in the same way as debtors. The amount of credit the Society is taking from its suppliers can be calculated by the ratio:

Purchases / Creditors = 69,000 / 15,900 = 4.34 = 84 days credit

This ratio includes all supplies, including items charged to overheads. It could be separated between suppliers of raw materials and indirect items, as the figure for creditors is broken down in the balance sheet. Credit taken from raw material suppliers would be:

( 13.200 / 52.800 ) X 365 = 90 days

and from suppliers of items charged to overheads would be

2700 x 365 = 60 days.

It is possible that suppliers would not be content to allow this situation to continue. Even without past statements for identification of trends by comparative ratio analysis over two or more years, it is likely that Fibre Mat Society is heading for difficult times.

(ii) Profitability and liquidity

The problem is essentially this: although the Society is trading profitably at present, its cash is tied up in excessively high levels of debtors and stocks. The conversion of assets into cash is unacceptably slow.

The management of working capital seeks to obtain the right level of liquidity. A business with insufficient liquidity, if unable to delay payments or borrow externally, could face technical insolvency. This is a situation where sufficient assets exist to meet liabilities, but they cannot be converted quickly enough into cash. It is different from legal insolvency, a state in which assets are actually insufficient to meet liabilities.

Conversely, an over liquid enterprise is guilty of idleness: keeping too high a level of cash and other liquid assets, rather than investing them in strategies for growth.

Consider the current position. The Society has 5,000 in cash, the most liquid asset. It has short-term cash payment obligations of 22,500 creditors and deferred wages, even discounting its bank overdraft. How can it meet these obligations unless stocks and debtors are turned quickly into cash?

It is in the first instance for the purpose of ensuring adequate liquidity to meet operational needs that working capital management is a fundamental part of the financial control of an enterprise.

(iii) The effect of liquidity difficulties

Profit and cash are separate concepts, and the evidence of one does not automatically imply the existence of the other. Yet, it is evident that a shortage of liquidity can affect profitability adversely.

First, it might necessitate borrowing externally in order to finance current assets. Profit is reduced by the amount of interest paid, by 5,550 in the case of Fibre Mat Society. In its estimate of overheads (Figure 2) the Society had apparently made very little allowance for bank interest.

Second, it might result in lost sales, because the expenditure necessary to finance production could not be met.

Third, the value of assets might undergo a reduction: some stock might become obsolescent, some debtors might go bad.

Fourth, it might oblige an enterprise to make short-term decisions which are not in its long-term interests.

Faced with a liquidity problem, and lack of access to external funds, a business has perhaps four courses of action open to it:

· Dispose of assets. Disposal of fixed assets, part of the permanent capital structure of the enterprise, might seriously impair operational capacity. The Society could sell its van; but leasing, or using public transport, might be more expensive. If stocks are sold off quickly, an amount less than their true value might be realised.

Debtors might be reduced, but to call cash in urgently might necessitate offering generous discounts. Imposing an excessively tight credit policy might alienate customers.

No asset should ever be left idle. There might be scope for leasing out under utilised assets. If Fibre Mat Society only uses its van four days a week, maybe it could be hired out the other three.

· Increase selling prices. This is fine if the market will accept it; if not, sales income is likely to decrease.

· Cut operating costs. If scope for efficiencies exist, then this is fine. What must be avoided is a reduction in quality of raw materials purchased, or cutting corners in production, which would reduce the quality of the finished products.

· Defer payments. In other words, increase liabilities, and hold on to the cash. Some additional credit might be available, but suppliers might be disaffected, causing future difficulties in obtaining supplies.

It is true that the objective of a social production unit would differ from that of a normal enterprise in that it is not profit-maximizing. It might be satisfied to realise a very small profit, or simply to break even, in order to achieve the basic aim of employment generation. Nevertheless, even such a unit wants to earn as much as possible so that it can either invest for growth, enabling further employment, or increase distributions in the form of wages or bonuses. Whatever the type of enterprise, or its corporate strategy, it should seek to run its affairs in the most efficient and profitable manner. Profit—or minimization of loss in a subsidised unit—is always the means to achieve the objective of a business, whether that objective is that the proprietors make a personal profit or that some social benefit results.

The concept of working capital is ultimately related to that of profit. Profit is the objective of operations; working capital is the means to undertake operations. It is vital to keep this perspective in view, because whilst working capital may be concerned with only short-term assets and liabilities, an enterprise's liquidity position will influence its profit performance. This is the second fundamental purpose of working capital management.