Secretarial Practice · Ch 1 — Introduction to Corporate Finance
Capital Requirements of a Company — Working Capital
Capital Requirements of a Company — Working Capital
5. Capital Requirements of a Company — Working Capital
Meaning of Working Capital. Working capital refers to the funds a company needs for its day-to-day operations — to purchase raw material, pay wages and other operating expenses, hold stock of finished goods, extend credit to debtors, and meet other short-term, recurring needs of the business. Unlike fixed capital, working capital is not locked away in one place; it keeps circulating continuously through the business's operating cycle — cash is used to buy raw material, raw material becomes finished stock, stock is sold to generate debtors or cash, and the cash so realised is used to buy raw material again.
A working definition. Working capital is that part of a company's total capital which is invested in current assets — such as stock, debtors, and cash — and is required to meet the day-to-day operating expenses of the business; it is raised repeatedly, in a short and continuously recurring cycle, rather than once for the whole life of the business.
Gross working capital vs. net working capital. Working capital may be understood in two related senses: gross working capital, which is simply the company's total investment in current assets, and net working capital, which is current assets minus current liabilities — the true cushion of short-term funds available to the company after its short-term obligations are met.
Factors affecting the requirement for working capital:
- Nature of the business. A trading company that turns over its stock quickly needs comparatively less working capital than a manufacturing company, which must fund raw material, work-in-progress, and finished stock all at once through a longer operating cycle.
- Scale of operations. A larger volume of production and sales requires a correspondingly larger investment in stock, debtors, and cash to support that higher level of activity.
- Length of the operating cycle. The longer the time gap between spending cash on raw material and receiving cash back from sales, the greater the amount of working capital the company must keep tied up to bridge that gap.
- Credit policy. A company that sells largely on credit (allowing debtors a long period to pay) needs more working capital than one that sells mostly for cash, because funds remain locked up in debtors for longer.
- Terms of purchase. Conversely, a company that itself enjoys longer credit from its own suppliers needs less working capital of its own, since part of its short-term funding is effectively provided by creditors.
- Seasonal fluctuations. A business with a pronounced seasonal pattern (for example, one that must build up stock heavily before a peak season) requires a larger working-capital cushion at certain times of the year than at others.
- Rate of stock turnover. A business where stock sells and is replenished quickly needs less working capital tied up in stock at any one time than a business where stock moves slowly.
Distinguishing Fixed Capital from Working Capital:
| Basis | Fixed Capital | Working Capital |
|---|---|---|
| Meaning | Capital invested in fixed assets used over a long period | Capital invested in current assets to meet day-to-day operating needs |
| Purpose | To establish and equip the business (land, buildings, machinery) | To run the business's daily operations (raw material, wages, stock, debtors) |
| Period of investment | Long-term — invested once and kept blocked for a long duration | Short-term — raised and recovered repeatedly in a continuously recurring cycle |
| Liquidity | Not easily convertible into cash without disrupting the business | Readily convertible into cash in the normal course of business |
That part of a company's total capital invested in current assets (stock, debtors, cash) and required to meet the day-to-day operating expenses of the business; raised and recovered repeatedly in a …
Current assets minus current liabilities — the true surplus of short-term funds available to a company after meeting its s …
The continuous cycle by which cash is converted into raw material, raw material into finished stock, stock into debtors or cash on sale, …