Working capital is one of those phrases that many people have heard of but are perhaps not entirely sure what it means.
The official definition of working capital is current assets less current liabilities. Current assets and current liabilities can be seen on your company’s balance sheet. “Current” means within the next 12 months, i.e. assets that you will receive money for within the next 12 months and liabilities or money that you will need to pay out in the next 12 months. Therefore, working capital shows the short term health of your organisation. To be financially healthy in the short term, working capital should be a positive figure, i.e. more current assets than current liabilities. These assets will then pay for these liabilities.
Current assets include any stock that you will be selling, debtors who are your customers who owe you money and also cash in the bank (although this is sometimes excluded from the working capital calculation). Current liabilities are any monies you owe within the next 12 months. Typically, this list would include creditors (your suppliers), VAT, corporation tax, overdrafts and any loans repayable within the next 12 months.
So what happens if we don’t look after our working capital position? Perhaps this is best explained with an example of a company I went to help rescue for this very reason.
This company was heading into administration, i.e. was rapidly running out of money. And there was no need for it to. It was and should have continued to be a successful business. The working capital position wasn’t being managed at all hence attempting to turn it around.
How would the Board have known that the working capital position was so poor?
The aged debt report, which shows how old debts are that are due from our customers, showed the majority of customers in this company hadn’t paid for over 120 days. They clearly were not on top of collecting monies due! Getting money in from customers is absolutely vital and should be a top priority of any business. Remember that no cash = no business. Lord Alan Sugar himself says “getting paid is THE most important part of business.”
The stock report quickly showed very old and now obsolete stock that the company could no longer sell. This company had paid good money to buy all this stock and then there were the costs of keeping it in the warehouse. If you’ve ever watched Dragon’s Den, you’ll know one of the key questions of the Dragons is about stock turnover, i.e. how quickly they sell their stock and get the money back in, at a profit. You need to sell stock and in good time.
And because this company wasn’t getting money in from its customers or from selling stock, it therefore had very little cash to pay its suppliers and bills which was understandably causing significant problems.
All of these issues were relatively easily rectifiable. Their finance director was sacked for doing a very poor job. However, the Board have the same level of responsibility for the financial health of their organisation. If they had known what questions to ask, this could all have been avoided.
Therefore, I would encourage you to spend some time looking at your working capital position and understanding it. Good luck!
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