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Working capital management
Working capital is important to the financial management of a business, as it is indicates its ability to pay its debts, or short-term liabilities, when they fall due.
The effective management of working capital is necessary to achieve the long- and short-term goals of business.
Outcomes
Overview of the working capital ratio
Revision and case study data
More
Outcomes
The student:
| H2.1 | describes and analyses business functions and operations and their impact on business success |
|---|---|
| H4.2 | evaluates management strategies in response to internal and external factors |
| H5.3 | communicates business information, ideas and issues, using relevant business terminology and concepts in appropriate forms |
| H5.4 | applies mathematical concepts appropriately in business situations. |
Overview of the working capital ratio
Working capital is defined as:
CURRENT ASSETS minus CURRENT LIABILITIES
Working Capital can also be expressed as a ratio:
Current ratio (Working capital ratio) = CURRENT
ASSETS : CURRENT LIABILITIES
e.g. if current assets are $15 000 and current liabilities
$10 000, the working capital ratio is:
15 000 : 10 000 = 3 : 2, or 1.5 : 1.
Working capital indicates the liquidity of a business. A business with poor liquidity has difficulty in paying its everyday expenses, e.g. rent, telephone bills, wages and salaries. If management does not constantly monitor and manage a business's liquidity - that is, its amount of working capital - the business can find itself in a difficult situation with its creditors.
Remember these key points about working capital:
- The current assets (cash, inventories/stock and
accounts receivable/debtors) in the business need to be
monitored and kept at realistic levels.
- Current liabilities constitute all the short-term
payments that need to be met by the business (obligations
that need to be paid within one year). Short-term loans and
accounts payable are examples.
- Most successful businesses keep the working capital
ratio as low as possible, and keep cash circulating, so as
to maximise profit.
- The size of the working capital ratio depends on the type of industry the business operates in, and on financial arrangements such as overdrafts and creditor policy. Ratios between 1.5 : 1 and 2 : 1 are acceptable for most businesses.
Example
Daniel’s Hockey Shop, a hypothetical business
with current assets of $50 000 and current liabilities of $25
000, has working capital of $25 000 ($50 000 minus $25 000).
The business has $2 of current assets for every $1 of current
liabilities. Daniel's working capital or current ratio is
expressed as 2:1.
This business seems to have an adequate working capital and a safe working capital ratio. This business appears also to be liquid.
Working capital (current) ratios may vary
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Situation 1
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Adequate or safe working capital ratio for most businesses. |
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Current assets
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:
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Current liabilities
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$50 000
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:
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$25 000
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2
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:
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1
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Situation 2
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: |
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A ratio generally considered too low for most businesses, but often seen in businesses with high stock turnovers and few accounts receivable, such as fruit shops. |
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Current assets
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:
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Current liabilities
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$50 000
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:
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$50 000
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1
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:
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1
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Situation 3
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: |
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A ratio generally considered too low or unsafe. In this situation, the business has only 80 cents of current assets to pay for every dollar in current liabilities. Exceptions could be large companies with continuously high and predictable cash flows, such as Telstra or Woolworths. |
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Current assets
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:
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Current liabilities
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$20 000
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:
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$25 000
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0.8
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:
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1
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A real-life situation
Sports Girl Fashions, a chain store which began operations in the late 1970s and had many retail outlets across Australia, was forced to appoint an administrator in November 1999. They were broke.
The factors that contributed to its poor financial position were its mounting debts ($60 million) and its poor sales in the winter season.
Sports Girl management must have failed to monitor trends in a rapidly changing fashion market. As a result, the company ran out of cash sufficient to meet short-term liabilities. Funds were tied up in out-of-fashion stock and fixed assets, which created a liquidity problem. The business did not have adequate working capital to continue trading.
Revision and case study data
Summary of selected financial data for a small business:
Joan & Kate's Modern Swimwear
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Dec/Feb
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Jun/Aug
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Dec/Feb
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Jun/Aug
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| 99/00 | 99 | 99/00 | 99 | |||
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ASSETS
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$
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$
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LIABILITIES
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$
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$
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|---|---|---|---|---|---|---|
| Cash in Bank | 1000 | 10000 | Mortgage | 10000 | 9500 | |
| Inventory | 3000 | 8000 | Accounts Payable | 4000 | 6000 | |
| Accounts Receivable | 5000 | 4000 | Overdraft | 5000 | 1000 | |
| Prepaid Expenses | 1000 | 0 | Capital | 8000 | 8000 | |
| Delivery Van | 5000 | 5000 | ||||
| Fixtures & Fittings | 3000 | 3000 |
Activities
- Identify the current assets and current liabilities in Joan & Kate's financial extract.
- Calculate current assets and current liabilities for the selected financial periods.
- Calculate the working capital and the working capital ratio for each financial period.
- Comment on the liquidity of the business over the two periods.
- Suggest two management strategies that the owners of the business could use to improve liquidity.
Telstra The Future Is Looking Good:
In examining Telstra's annual report the primary source of liquidity generated from its operations was cash, an increase of 16.7% in 1999. This increase was due to growth of revenue and improved cash flows from customers.
In common with most telecommunication companies, Telstra current liabilities are in excess of their current liabilities.
The management of the company indicated that it does not consider this negative working capital position a risk to liquidity because they can delay spending on future projects in the event of cash flow problems.
| Assets and Liabilities | |
|---|---|
 |
 |
 |
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Using the financial information for Telstra:
- Find the dollar amount for working capital for each financial period.
- Calculate the current ratio for each financial period.
- Outline and comment on the trends in the liquidity position over the two years.
- Suggest reasons why Telstra's liquidity position is not a problem for the long-term prospects of the business.
More
Try your luck with some financial reports Telstra's
annual report can be found via the
Telstra Investor relations 
Business Review Weekly
Exam hint
After looking at a number of financial reports and using the financial ratios in this tutorial, you should now be a financial wizard. Wherever possible, refer to real-life ratio situations in assessments and examinations.
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