Study Notes: Business Finance & Accounting

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
- Work-in-progress
- Finished goods
- Trade debtors
- Prepayments
- Cash balances

Current Liabilities include:
- Trade creditors
- Accruals
- 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.