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.