How much working capital should a company have?

How much working capital should a company have? Share

Relevant to ACA – Management Information

Working capital is one of the most difficult financial concepts for small business owners to understand but it trips a lot of students up too!

Working capital is the amount by which current assets exceed current liabilities and represents the capital a company has available to conduct its day-to-day business. For example, if a company’s balance sheet reports total current assets of £126,000 and total current liabilities of £113,000 then the company’s working capital is £13,000. But how much working capital should a business have? Too much working capital means the company has surplus funds which are not earning a return and too little may mean the company faces financial difficulties.

Good working capital management means getting the balance right between profitability (investing in longer term assets to maximise return) and liquidity (ensuring a sufficient level of current assets to minimise the risk of insolvency). For example, a profitable company could fail if they don’t have the cash to pay their wages so implementing an effective working capital management system is crucial.

Just knowing that you have £13,000 in working capital is not going to help you much! If it was your business you would want to know what your working capital needs are and how you might meet them. This is exactly what the learning outcome in the Management Information syllabus is referring to when it says calculate the cash cycle for a business and recognise its significance.

A useful tool for determining working capital needs is the working capital or operating cycle. This analyses accounts receivable, inventory and accounts payable cycles in terms of days. In other words it analyses the length of time between paying for the purchase of goods and receiving cash for the subsequent sale.

As sales increase so too does the need for inventory and purchases which means more cash is tied up in the cycle. If the cycle is out of balance extra short term finance is needed and for many businesses it is not possible to finance this with accounts payable financing alone (this would be an aggressive working capital management policy). The shortfall might typically be covered by the net profits (Equity) generated internally or externally by borrowed funds (Debt), or by a combination of the two. The important thing here is to plan ahead!

Now make sure you know some of the advantages and disadvantages of both short–term and long term finance.

Jan Weston

Professional Education Manager and Tutor

Reed Business School

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