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An introduction to effective working capital (liquidity) management
This tutorial was written by
Michael Lembach
HSIE Project Officer
Introduction
The term working capital refers to those funds that are needed for the ongoing daily expenses of a business, such as rent, advertising, telephone and wages. Working capital provides cash for short-term liquidity. This tutorial is an overview of the role of working capital as a part of the entire business operation.
Outcomes
Working capital management versus
profitability and revision
The current (working capital) ratio and the
quick (acid test) ratio and revision
Working capital management and the business
life cycle and revision
Outcomes
HSC Topic 2: Financial Planning and Management is covered in the Board of Studies NSW Syllabus (June 1999) on pages 27-29. The specific outcomes for this section are:
The student:
| H2.1 | describes and analyses business functions and operations and their impact on business success |
|---|---|
| H3.3 | analyses the impact of management decision-making on stakeholders |
| H5.4 | applies mathematical concepts appropriately in business situations. |
Working capital management (liquidity) versus profitability
Many observers and analysts, when gauging how well a business is going, look solely at profitability. Of course, profitability is a major consideration. Being in an unprofitable business is a personal tragedy for many owners and managers who work long and hard, and yet do not earn a satisfactory return on their investments.
But, and this is an important point, poor or below average profitability is not necessarily terminal for a business. Effective working capital (liquidity) management is equally if not far more significant. It is absolutely vital to a business' success.
Often poor or below average profitability situations can be changed, but not unless effective working capital management practices have already been implemented.
A real life illustration
We'll ride the storms
BHP defiant despite profit slippage
In August 2002 BHP Billiton, the Melbourne based transnational resource giant group, announced a dramatic $400 plus million dollar fall in profitability from the previous financial year.
However, it boasted that a strong balance sheet, surging cash flows, its high class assets and a clamp on costs left it "well placed to prosper where others might not".
Particularly pleasing for the company was the strong rise in operating cash flow to $7.45 billion before interest and tax. When taken together with the group's low debt to equity ratio. BHP Billiton clearly retains firepower to act on any opportunities that may arise.
The company will stay in business, but will also immediately implement changes to correct the profitability situation for the next financial year. BHP Billiton will be able to continue trading largely because management practises effective working capital (liquidity) strategies.
Adapted from The Daily
Telegraph
Thursday 9 August 2002
Net working capital is defined as the difference between current assets and current liabilities. It is a measure of a business' ability to pay their debts as they become due. Whereas poor profitability can be very annoying and distressing, poor liquidity is worse. A business that is not liquid (does not have a surplus of current assets that it can convert to cash) becomes unable to meet payments such as rent, telephone and payroll. This can be terminal for the business.
For example
Mark's Washing Machine Repairs, a hypothetical business with current assets of $40 000 and current liabilities of $20 000, has working capital of $20 000 ($40 000 less $20 000). The business has $2.00 of current assets for every $1.00 of current liabilities.
Mark's working capital or current ratio is expressed as 2:1. This business appears to have an adequate amount of working capital and a 'safe' working capital ratio. This business also appears to be liquid, although that may not always be the case as we shall see below.
Liquidity is closely related to the concept of working capital, but it is not exactly the same. A business may have adequate working capital as represented by a large inventory and big dollar amounts of accounts receivable, but still may not be able to pay their current liabilities.
Creditors do not accept inventories and accounts receivable. They need cash to keep their own businesses viable.
For example
Mark's balance sheet could look like this.
|
Current
assets |
Current
liabilities |
||
|---|---|---|---|
| Cash | $5 000 | Accounts payable | $15 000 |
| Accounts receivable | $20 000 | Overdraft | $5 000 |
| Inventory | $15 000 | ||
|
Total
|
$40 000 |
Total
|
$20 000 |
In this situation Mark is not liquid, although on paper his working capital looks fine. However, he only has $5 000 in ready cash to meet current obligations of $15 000. Unless Mark has some quick cash sales or can collect some of his accounts receivable, he will probably be forced to increase his overdraft.
What is an overdraft? An overdraft is a short term loan that a bank makes to a business. It is an arrangement where the business is allowed to write cheques or to draw funds against their business account for more than the business has on deposit.
For this privilege the bank charges monthly interest to the bank for the amount the business is "overdrawn". Overdrafts are traditionally secured by real property (land or buildings) and, although convenient, are an expensive form of finance.
Inventory and accounts receivable (debtors) represent a blockage of the proprietor's funds. A blockage occurs when money becomes tied up in slow paying debtors, or in slow moving stock. In such a case the business may appear to have a satisfactory amount of working capital but little or no liquidity.
A blockage of funds is taking place in Mark's business above. Maintaining the correct balance of current assets is the essence of working capital management.
Review and discussion questions:
- Why is it often a mistake to judge a firm's financial progress simply on the basis of profitability? (outcome H2.1)
- How can working capital (liquidity) management ever be considered more important than profitability? Can you give an example from a business you have studied of a situation where profitability was not as important as effective working capital (liquidity) management? (outcome H3.3)
- What do you understand as the difference between liquidity and working capital? (outcome 5.4)
- What ratio is commonly used to express a firms' working capital ratio? (outcome 5.4)
- Why do you think banks often insist on securing overdraft arrangements with real property? Are there any disadvantages to a business that chooses to offer security on their real property in exchange for the privilege of having an overdraft facility? (outcome H2.1)
The current (working capital) ratio and the quick (acid test) ratio
This formula is used to calculate the current (working capital) ratio in any situation.
Current ratio = total current assets/current liabilities = (times)
|
For example
|
|||
|---|---|---|---|
| Refer to our previous example of Mark's
Washing Machine Repairs.
Calculating the current ratio is not difficult |
|||
| Total current assets $40 000/ Total current liabilities $20 000 | =2.0 times | ||
| (Written as a ratio 2:1) | |||
If Mark's total current assets were $60 000 and his total current liabilities were $20 000, then his current ratio would be 3:1 ($60 000 / $20 000).
Conversely, if Mark's total current assets were $30 000 and his total current liabilities were $20 000 then his current ratio would be 1.5:1 ($30 000 / $20 000).
This formula remains the same for all businesses regardless of size or type of operation. It is correctly called either the current ratio or the working capital ratio.
What is an acceptable current ratio? For some time a common standard for current ratios was 2:1. That standard was based on the generalisation that inventory usually made up half of the current assets in typical business situations. In recent times this benchmark has often been lowered as businesses have:
- adopted more sophisticated inventory control systems
- focused on the more efficient use of short term
financial resources
and - tightened their policies on accounts receivable (debtors).
For example
A business such as a hot bread shop normally has no accounts receivable and a high inventory turnover, hopefully every day. Such a business is normally able to operate on a current ratio of 1:1 or even slightly lower.
Larger food store chains, such as Coles and Woolworths, typically have lower current ratios than other large Australian companies for the same reason. Supermarkets typically have very short cash flow cycles.
The quick (acid test) ratio:
This ratio provides a more stringent test of a firm's
liquidity because it does not include inventory as a current
asset, nor does it include bank overdraft as a liability.
This ratio is a better indicator of a firm's ability to
meet current commitments "in a hurry".
This formula is used to calculate the quick (acid test) ratio in any situation.
| Quick ratio = | Current assets - inventory/
Current liabilities - overdraft |
=(times)
|
|---|
For example:
Refer again to our example of Mark's Washing Machine Repairs.
Current Assets $40 000 - inventory $15 000 = $25 000 = 1.67 times
Current liabilities $20 000 - overdraft $5 000= $15 000
(Written as a ratio 1.67:1)
Inventory is excluded from current assets because it normally takes some time to convert stock into cash. Firms desperate to raise cash often liquidate inventories at a loss, so the inventory stated on the balance sheet may not always be 100% accurate.
In our hypothetical washing machine repair case, Mark's current ratio and his quick ratio vary, a typical situation and a good reason why business analysts should not rely on numbers alone. Mark has a high percentage of his current assets tied up in inventory and accounts receivable, a potential blockage problem.
In interpreting current ratios and acid test liquidity ratios it is important to keep the quality of the assets in mind. High "safe" ratios are of little comfort if inventory cannot be sold and debtors will not pay. The prudent manager analyses liquidity ratios in conjunction with the turnover ratios for current assets.
A hypothetical illustration of ratios in practice
Some small service businesses are not overly concerned with maintaining "acceptable" quick rations.
Kiwi Kleaners is a hypothetical business, not unlike numerous other small service busineses. Kiwi operates a window cleaning service that specialises in homes in Sydney's Eastern Suburbs. They keep no inventory other than cleaning supplies, nor do they have any accounts receivable. All their clients pay cash on the day of service.
Kiwi Kleaners does not have a bank overdraft and rarely has any large operational expenses. Its business is well established with loyal customers and with more home owners on a waiting list. For the past seven years the business has provided the two partners with a steady and predictable cash flow.
The Kiwi Kleaners proprietors are not interested in expanding and so they have no marketing expenses. The proprietors simply put aside surplus cash in a reserve account which they use when necessary, more often than not for a trip back to New Zealand. It is a nice clean business.
Review and discussion questions
-
In reference to a business you have studied: (outcome
H5.4)
- calculate or estimate both its current and quick ratios
- outline your opinion of its working capital (liquidity) management practices.
- Explain the difference between the current (working capital) and the quick (acid test) ratios. (outcome H5.4)
- Comment on the limitations of liquidity ratios. (outcome H2.1)
- Describe the significance in the difference between a current ratio of 3:1 and a current ratio of 2:1. (outcome H2.1)
- What is your opinion of the Kiwi Kleaner view on effective working capital (liquidity) management? (outcome H3.3)
Working capital management and the business life cycle
Effective working capital (liquidity) management is critical in all stages of the business life cycle. When the business establishes operations, there are dozens of start up expenses such as:
- legal and professional advisers' fees
- accountant's set up charges, lease deposits and rent in advance
- cost of initial inventory for firms reselling merchandise
- initial advertising and promotion costs
- stationery and printing
- shop fitting and office equipment purchases
- wages and on costs for employees
- license and registration fees
- insurance premiums, always payable in advance
- telephone and fax connection charges
- equipment leasing payments
- utility deposits (e.g. water, gas, electricity)
- bank charges or loan set up costs
- owner's personal living expenses while the business is becoming established.
These up front charges can and often do amount to thousands of dollars and are frequently dramatically under estimated by many intending business owners. In most cases the business will not produce enough initial revenue to meet these start up expenses until the business begins to grow. The proprietor needs to plan for and to provide enough working capital to see the business through the establishment stage.
As the business grows, revenue increases, but so do variable costs. Expanding businesses need bigger premises, more employees and updated equipment.
Additionally there is the nightmare of credit or account customers. Costs are incurred as the business gets the products or services out, but there may be a wait of 30, 60 or even 90 days or more before the business receives payment. The amount of cash a business has tied up in accounts receivable reduces the amount the managers have to pay their own bills. If necessary funds are blocked (tied up) in overdue accounts, the owner may be forced to increase the size of the business' overdraft in order to meet current business commitments.
The necessity of having adequate working capital never does completely "go away". As the business enters the maturity and post maturity stages of the business life cycle, owners and managers constantly need to remain aware of working capital management. Businesses in the later stages of the business life cycle and the product life cycle often face the situation of having to "write off" obsolete inventory.
For example
Classic Records was a long established Sydney specialty music store that kept an extensive stock of hard to find country and classical long play records.
Even as technology changed and compact disks entered the market place, Classic stuck with long play records, in spite of dwindling customer demand.
In the end there was no demand for their huge once valuable inventory sand the company ceased trading. The owners, by losing control of their inventory (a vital current asst) failed to effectively manage their working capital
Review and discussion questions:
- When, in your opinion, is the most critical time in the business life cycle for a business to be concerned with the management of its working capital? (outcome H3.3)
- Place yourself in the position of managing director of Classic Records in the previous example. What steps could you have taken to correct the situation? (outcome H3.3)
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