As an introduction to the working capital cycle, here is a quick reminder of the main types of cash inflow and outflow in a typical business:
Inflows
Outflows
Cash sales to customers
Purchasing finished goods for re-sale
Receipts from customers who were allowed to buy on credit (trade debtors)
Purchasing raw materials and other components needed for the manufacturing of the final product
Interest on bank and other balances
Paying salaries and wages and other operating expenses
Proceeds from sale of fixed assets
Purchasing fixed assets
Investment by shareholders
Paying the interest on, or repayment of loans
Paying taxes
Cash flow can be described as a cycle:
The business uses cash to acquire resources (assets such as stocks)
The resources are put to work and goods and services produced. These are then sold to customers
Some customers pay in cash (great), but others ask for time to pay. Eventually they pay and these funds are used to settle any liabilities of the business (e.g. pay suppliers)
And so the cycle repeats
Hopefully, each time through the cash flow cycle, a little more money is put back into the business than flows out. But not necessarily, and if management don’t carefully monitor cash flow and take corrective action when necessary, a business may find itself sinking into trouble.
The cash needed to make the cycle above work effectively is known as working capital.
Working capital is the cash needed to pay for the day to day operations of the business.
In other words, working capital is needed by the business to:
Pay suppliers and other creditors
Pay employees
Pay for stocks
Allow for customers who are allowed to buy now, but pay later (so-called “trade debtors”)
What is crucially important, therefore, is that a business actively manages working capital. It is the timing of cash flows which can be vital to the success, or otherwise, of the business. Just because a business is making a profit does not necessarily mean that there is cash coming into and out of the business.
There are many advantages to a business that actively manages its cash flow:
It knows where its cash is tied up, spotting potential bottlenecks and acting to reduce their impact
It can plan ahead with more confidence. Management are in better control of the business and can make informed decisions for future development and expansion
It can reduce its dependence on the bank and save interest charges
It can identify surpluses which can be invested to earn interest
