Understanding Working capital - Part 1

Working capital is a critical component in the functioning of any business. Working capital is akin to the oxygen supply for a business. Any disruption in the availability of adequate and timely working capital can immobilize the company operations, and jeopardize its overall financials. As the name suggests, working capital is the capital required to run the day-to-day affairs of the company. After the initial investment of setting up the factory and installing plant & machinery, the company additionally requires funds to keep its machines working and churning out goods.

Essentially the company must have funds to buy raw material, to pay wages to workers and to bear other operating expenses required for daily production. After operating funds are spent and goods are produced, there is a time-lag before actual sales are realized. Even after a sales transaction is concluded, it does not immediately bring in cash for the company as a credit period is often extended to the buyer. In a nutshell, a company needs working capital to continuously produce sufficient goods as the actual cash realization of sale proceeds takes place much later after a sale is made.

The working capital for any company is the value of raw material inventory, its WIP (work in process) inventory, its finished goods inventory and receivables it has at any point of time. Basically these make up the current assets of the company. Working capital is funded via a combination of sources. A part of the working capital required is funded by cash generated from operations. Then, the payables credit period reduces the amount of the working capital needed. The portion of working capital that still remains to be serviced after use of internal cash accruals and current liabilities, is the working capital gap which is also known as Net working capital. This working capital gap is funded by bank borrowings in the form of short term loans. Key relationships are shown below.

Working capital = Current Assets = Inventory + Receivables

Working capital gap = Current Assets (excluding cash & bank balance) - Current Liabilities

So, high working capital entails a cost to the firm in the form of short term loan interest payments. The greater the working capital gap, the larger is the amount to be borrowed and so higher is the servicing cost. Thus high working capital gap reduces the profits of the company. This also creates a chronically weak situation with lower than desired cash reserves and a perennial dependence on external funds. As a result, the company's competitive edge dwindles in the long run.

The ideal scenario is when the company's working capital is serviced internally without relying on costly loans. This works well in case of cash rich companies such as mining companies. Even in less ideal situations, the net working capital can be significantly reduced by efficient inventory and receivables management. This fundamentally involves reducing raw material and finished goods holding periods and expediting debtor collection, thereby lowering working capital needs.

Interestingly, industry dynamics also play a vital role in determining the working capital cycle. In the second part of this series, we shall discuss in detail the working capital cycle across industries and its implications on profitability.