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

Revision Note

Written by: Danielle Maguire

Reviewed by: Steve Vorster

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

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

Shortage of Working Capital	Excess of Working Capital
Businesses may look to convert debtors and stock into cash as quickly as possible. This may mean they have to sell stock at low prices, reducing revenue Suppliers may not allow an extension of trade credit terms as the business is seen as too much of a risk Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation but relatively high level of interest must be paid	Holding large amounts of cash may mean missing out on benefits of investing it in fixed assets or investments This may represent a significant [popover id="rwgdJTaybPhZJ4sJ" label="opportunity cost"], as the money is not being put to work for the business If a business is holding large amounts of stock, it may incur extra storage costs, and the cash value of the stock could be used for other purposes

Shortage of Working Capital

Excess of Working Capital

Businesses may look to convert debtors and stock into cash as quickly as possible. This may mean they have to sell stock at low prices, reducing revenue
Suppliers may not allow an extension of trade credit terms as the business is seen as too much of a risk
Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation but relatively high level of interest must be paid

Holding large amounts of cash may mean missing out on benefits of investing it in fixed assets or investments
This may represent a significant [popover id="rwgdJTaybPhZJ4sJ" label="opportunity cost"], as the money is not being put to work for the business
If a business is holding large amounts of stock, it may incur extra storage costs, and the cash value of the stock could be used for other purposes

Last updated: 23 October 2024

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