10. Working capital

Chapter 10



by: josavere

It is defined as the difference between current assets and current liabilities or also as the proportion of current assets financed with long-term funds.

According to basic principles of finance, working capital is the equivalent to the minimum of current assets (cash, banks, temporary investments, accounts receivables and inventories) that a company must finance with its own resources or with long term debt or with margin of contribution.

In an economy that is rapidly changing, the great advances in telecommunications have shortened the distances and some of the principles stated by the classical economist questioned because they never thought of radical change in the business people.

Working capital is defined as the assets and liabilities that can be turned into cash in a period of time of less than one year. For practical purposes, it is more logical to define the short term as the time for the operative cycle of the company. In other words, the period of time between the buying of raw materials and the collection of accounts receivables; this short term has a variable duration depending on the type of business for financial purposes. Current assets are: 

a. Cash and banks
b. Temporary investments
c.  Receivable accounts
d. Inventories:
•   Raw materials
•   Work in process
•   Finished good 

The productive cycle starts buying raw materials, adding value to them through the accumulation of direct and indirect material; the use of labor, and obtaining a finished product that is sold usually on credit afterward. Those receivables are collected at the cost and obtaining a profit, this cycle repeats self. If the product sells with a good margin a profit is obtained and liquidity is looked for. 

This liquidity allows the company to buy materials in optimal terms
(prompt delivery, good prices, good quality, and discounts for early payments) allowing the corporation efficiency in its plant capacity, improves its productivity, reduce costs, and be able to compete in the market with competitive prices. 

Liquidity and profitability are very closely related. The only time when this relationship is questioned is when a corporation does not have analyzed enough its projected cash flow.

If we have a good stimulation of the inflows and outflows of cash, all excess liquidity means a reduction of profitability to the amount that those excesses could be put to gain interest instead of helping, then without earning anything.

On the contrary, a deficit means the risk of not being able to pay and increase financial mistake which bring the lost of managerial capacity.

Generally, financial writers have two assumptions:

  • Short term money is cheaper than long term money
  • Current assets are less profitable than fix assets

Now we are going to discuss these two assumptions to learn how to deal with the situation.

In relation to the first assumption, short-term money sometimes has been much more expensive than long term money. The second assumption brings all doubts. First for all, the assumption has some logic because the fixed assets should be more profitable than current assets, on the contrary nobody build infrastructure, people simply would put the money in a financial institution.

Only with the interchanging of fix and current assets could it be possible to add value and earn a profit. What is important then is to define the proportion of each asset; this is known as asset structure. 

The most modern equipment, located at the modern facility by them does not genera a profit. Only, when are operated by people using the best material and the rights products can do it.
Based on the prior analysis we can conclude that the projection of cash flow is a basic to manage the working capital to the company. The following are some of the principles used to calculate the cash flow. 

1. Only those transactions that have inflows or outflows are taken into consideration also, the date of occurrence.

2. After finishing the projections, a careful review of the payments must be made and special attention and should be put into capital authorization and interest expenses.

3. In the outflow section, a degree of occurrence is expected, because liabilities have to be paid in predetermined dates.

4. In relation to inflows, caution is recommended to a new assumption that your customers will pay on time. The best way to project this is to use historical data or use all the experience the company has in this field.

All these considerations help to build a conservative cash flow budget; it is better to be conservative than optimistic, it is much easier to put money to earn interest than go out and get funds in a short notice.

Don´t forget to treat financial numbers which are only one part of the analysis, some quantitative aspects become very important when the cash flow budget is going to be approved.

In inflationary economies, it is recommended to work with standard costs in order to maintain the buying power of the exports as prices of raw materials increase reacquiring increments in working capital.

Inflation is a discrete variable and can be easily programmed in our electronic page where we are doing the projections. In periods of inflation, it is recommended a faster depreciation, cost system using LIFO, and being conservative in applying the accounting principles.

Returning to the issue of surplus liquidity, this eventuality is easy to solve; placing money, even for a short time, is completely simple; Today there are so-called "money tables" that take cash for a weekend, or for a day and sometimes for a few hours. Another opportunity is that when a specific liquidity surplus is available, a supplier is called and an additional discount is negotiated with him for making the payment in advance of the terms already agreed. This is especially effective if the opportunity arises in the vicinity of extraordinary and large obligations, such as the Christmas bonus, or the provision of severance pay; even, sometimes it works in the month-end week, which generally brings with it the payment of payroll and other expenses at the end of the period.

Using these principles the director of the company could present an estimate of earnings, therefore he will have less pressure to announce dividends, and besides, he will pay fewer taxes. He will indexes sacrifice in the short term such as return on equity but retain a good level of working capital needed to fight against inflationary pressures.

From the managerial, it is very important to attain levels of working capital by turnover; while more profits are obtained with money that has the same buying power from the least effect with the inflation. The accounting system must be simple enough to differentiate between speculative and earnings from operations. 


A. TYPE OF BUSINESS: This is a very important factor and is related to the financial capacity of the owners or investors profit. Some types of business practices do not need working capital because their generation of cash is very easy.

B. PRODUCTIVE CYCLE AND UNIT COST: the shorter, the productive cycle and the lower cost, the lower is the working capital. It needless working capital to manufacture underwear women's that men's suits.

C. SALES VOLUME: obviously, more capital is needed when there is more amount of sales.

D. BUYING AND SALES TERMS: the manufacturer can be using its supplies reacquiring less working capital.

E. INVENTORY TURNOVER AND ACCOUNTS RECEIVABLES: if the cash turnover faster, less working capital.

F. CYCLE OF THE BUSINESSES: it relates to the general conditions of macroeconomic type. When the economy works well is much easier to obtain credit and therefore less is required working capital. It is very important to remember that type of situation is temporary and it demands caution of the management.

G. SEASONALITY OF THE SALES: while the more stable are the sales, the easier it is to assemble a cycle of production (purchases) and to obtain a high level of efficiency, trimming the productive cycle and at the same time reducing the necessity of working capital. In the opposite case, it agrees to combine with products of opposite seasonality in order to stabilize the level of income.
A clear example of this is that of the pharmaceutical and cosmetic laboratories: in winter, the sale of anti-flu or anti-colds accelerates. In summer, on the other hand, the volume of orders is concentrated in sunscreens, refreshing lotions and insect repellents.

Copyright © 2020