Need and Importance of Working Capital

No business can run on fixed assets alone. A factory building and machinery cannot produce or sell anything unless the firm also has funds to buy raw material, pay wages while goods are being made, hold finished stock until it is sold, and wait for credit customers to pay. The gap in time between spending cash on inputs and finally receiving cash from customers is exactly what working capital exists to bridge.

Why a business needs working capital:

• To purchase raw material and stock. A trading firm must buy goods before it can sell them; a manufacturer must buy raw material before it can produce. Funds are tied up in stock until it is sold.
• To finance the credit period allowed to customers. When goods are sold on credit, cash is not received immediately; the firm must fund its operations during the period the money is owed by debtors.
• To meet day-to-day running expenses. Wages, salaries, rent, electricity, carriage and similar expenses must be paid regularly, often before the related sales revenue is collected.
• To hold a cushion of cash. Some cash and bank balance must always be kept to meet unexpected payments and to take advantage of cash-purchase discounts or sudden business opportunities.
• To maintain the firm's creditworthiness. A firm that pays its suppliers and short-term dues on time enjoys a good reputation and easier access to further credit.

The operating cycle explains the need. The operating cycle is the length of time between paying cash for raw material/stock and finally collecting cash from the sale of finished goods. In a trading concern it runs: cash → purchase of stock → sale of stock (on credit) → debtors → collection → cash again. The longer this cycle, the more working capital a firm must keep tied up to keep operating without interruption. …