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Working capital - why a business needs it

Author: Jim Riley  Last updated: Sunday 23 September, 2012

Working capital needs

Different industries have different optimum working capital profiles, reflecting their methods of doing business and what they are selling.

• Businesses with a lot of cash sales and few credit sales should have minimal trade debtors. Supermarkets are good examples of such businesses;

• Businesses that exist to trade in completed products will only have finished goods in stock. Compare this with manufacturers who will also have to maintain stocks of raw materials and work-in-progress.

• Some finished goods, notably foodstuffs, have to be sold within a limited period because of their perishable nature.

• Larger companies may be able to use their bargaining strength as customers to obtain more favourable, extended credit terms from suppliers. By contrast, smaller companies, particularly those that have recently started trading (and do not have a track record of credit worthiness) may be required to pay their suppliers immediately.

• Some businesses will receive their monies at certain times of the year, although they may incur expenses throughout the year at a fairly consistent level. This is often known as “seasonality” of cash flow. For example, travel agents have peak sales in the weeks immediately following Christmas.

Working capital needs also fluctuate during the year

The amount of funds tied up in working capital would not typically be a constant figure throughout the year.

Only in the most unusual of businesses would there be a constant need for working capital funding. For most businesses there would be weekly fluctuations.

Many businesses operate in industries that have seasonal changes in demand. This means that sales, stocks, debtors, etc. would be at higher levels at some predictable times of the year than at others.

In principle, the working capital need can be separated into two parts:

• A fixed part, and

• A fluctuating part

The fixed part is probably defined in amount as the minimum working capital requirement for the year. It is widely advocated that the firm should be funded in the way shown in the diagram below:

Working capital fluctuations

The more permanent needs (fixed assets and the fixed element of working capital) should be financed from fairly permanent sources (e.g. equity and loan stocks); the fluctuating element should be financed from a short-term source (e.g. a bank overdraft), which can be drawn on and repaid easily and at short notice.



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Starting a Business

Sources of Finance for a Startup
Franchising
Cash Flow Forecasting for a Startup
Creating & Protecting Business Ideas
Startups and Understanding the Market
Market Research for a Startup
Locating the Startup Business
Choosing a Legal Structure for a Startup
Employing People in a Startup
Generating and Protecting a Business Idea
Using Breakeven in Decision-Making

Finance

Revenues
Breakeven Basics
Costs, Revenues and Profits
Business Costs
Using Budgets
Using Breakeven in Decision-Making
Investment Appraisal Basics
Financial Strategies
Measuring and Improving Profit
Improving Cash Flow
Working Capital
Balance Sheet
Income Statement
Financial Efficiency Ratios
Profitability Ratios and ROCE
Liquidity Ratios
Gearing

Marketing

Competition
Products & Brands
Place (Distribution)
Promotion
Pricing
Price Elasticity of Demand

Business Organisation

Basics of Business Growth
Business Activities
Legal Structure Basics
Franchising
Sole Traders and Partnerships
Limited Companies
Generating and Protecting a Business Idea
Organisational Structures

People

Working in Teams
Communication Basics
Communication Methods
Workforce Planning
Recruitment, Selection & Training
Employee Motivation
Organisational Structures

Operations

Operational Objectives
Critical Path Analysis
Scale and Resource Mix
Lean Production
Capacity Management
Customer Service Basics
Managing Quality
Operational Decision-making
Using Technology in Operations
Working with Suppliers

Economic Environment

Economic Sectors
Government Spending & Taxation
Inflation
Unemployment
Interest Rates & Monetary Policy

Business Strategy

Leadership styles
Business Culture
Change Management







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INTRODUCTION TO ACCOUNTS
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