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
• 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
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
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
• 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:
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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