Author: Jim Riley Last updated: Sunday 23 September, 2012
The importance of working capital
Definition of working capital
The net working capital of a business is its current assets
less its current liabilities
Current Assets include:
- Stocks of raw materials
- Finished goods
- Trade debtors
- Cash balances
Current Liabilities include:
- Trade creditors
- Taxation payable
- Dividends payable
- Short term loans
Every business needs adequate liquid resources in order to maintain day-to-day
cash flow. It needs enough cash to pay wages and salaries as they fall due
and to pay creditors if it is to keep its workforce and ensure its supplies.
Maintaining adequate working capital is not just important in the short-term.
Sufficient liquidity must be maintained in order to ensure the survival of
the business in the long-term as well.
Even a profitable business may fail if it does not have adequate cash flow
to meet its liabilities as they fall due.
Therefore, when businesses make investment decisions they must not only consider
the financial outlay involved with acquiring the new machine or the new building,
etc, but must also take account of the additional current assets that are
usually involved with any expansion of activity.
Increased production tends to engender a need to hold additional stocks of
raw materials and work in progress. Increased sales usually means that the
level of debtors will increase. A general increase in the firm’s scale
of operations tends to imply a need for greater levels of cash.
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