The Importance of Working Capital (Cambridge (CIE) O Level Business Studies)

An Introduction to Working Capital

• Working capital is the money that a business has available to fund its day-to-day activities

• It is calculated using the formula

Working Capital = Current Assets - Current Liabilities

• Current assets include cash, cash equivalents or assets which can be converted to cash within a one year period

  • Cash

  • Debtors

  • Inventories (stock)

• Current liabilities are short-term financial obligations that are usually repayable within one year, or as demanded by creditors

  • Creditors

  • Short-term loans

  • Overdrafts

The Importance of Working Capital

• Working capital is vital to the day-to-day operation of a business

  • A lack of working capital often leads to business failure if the business cannot meet its immediate financial obligations

  • Cash is the most liquid of a business's current assets and can be used to settle debts immediately

  • Stock takes time to be sold and converted to cash to pay debts so is the least liquid current asset

• Effective management of working capital involves careful cash management

• If the finance manager is able to balance the flow of money in and out of the business, then the business is more likely to grow and be successful

• A business can hold too little or too much cash, both of which cause different issues 

The Problems of a Shortage or Excess of Working Capital