In most of a company’s lifetime, its core operations are dependent on the working capital and cash flow. This article is about the importance of working capital and cash flow analysis to a business. It also presents a brief description of what these business concepts are, and how to compute them.
Working Capital Definition
Working capital is described as a financial metric representing the business’ operating liquidity. Gross working capital is the same as the current assets of the business. However, the net working capital, or just the working capital is computed by subtracting the current liabilities from the current assets.
Working Capital Formula
Working capital formula, also known as net working capital formula is applicable in working capital calculation as shown below:
Working capital = Current assets – Current liabilities.
Note that in some cases the current liabilities can be more than the current assets in an organization or a business entity. This definitely results to a working capital with a negative value. In this case, the business is said to have a working capital deficit, implying that it does not have sufficient funds to satisfy all its operations. Have you now seen the importance of a positive working capital? While you are still thinking of that, you may be asking yourself the following questions:
What are current assets and current liabilities?
Current assets refer to cash and other assets that can be turned to cash within a period one year for example the company’s debtors while current liabilities refer to the debts and obligations that are due to the business entity within a period of one year for example short term loan.
What is capital?
Capital is the difference between the company’s total assets and total liabilities.
What is liquidity?
Liquidity is the measure of business’ ability to pay all its debts as they fall due.
What is Cash Flow?
Cash flow is simply the movement of cash into and out of the business measured after a certain period of time.
The company’s (total) net cash flow over a certain period of time is equal to change (difference) in cash balance over that period i.e cash flow at the end of the period minus cash flow in the beginning of the period.
This total cash flow is obtained by adding cash flows from the following three areas:
- Operating cash flows – refer to cash received or spent on internal business activities and includes changes in working capital. The operating cash flow formula is used to compute the net value of these activities (cash received minus cash spent), which must be positive for the company to remain solvent.
- Investment cash flows- Refer to cash received from selling long term assets or spent when acquiring long term assets.
- Financing cash flows- Refer to cash received from debtors or paid out to shareholders and (or) creditors.
Computing cash flow enables the company to evaluate whether more cash is being spent or becoming available in the business over the specified period. For example a positive cash flow implies that more cash is becoming available while negative cash flow implies that the company is spending more cash.
Can you think about this saying: “cash flow is to sanity, revenue is to vanity, but cash is the king?” This means that while it is better for a business to have large revenue inflows from sales, cash flow remains the most significant focus. Therefore, while a business can operate well in the short term to medium term regardless of whether it is making profit or loss by delaying payment to creditors to finance variable costs, it cannot survive for long without sufficient cash to satisfy its immediate needs.
Cash flow is important for financial institutions to decide whether to lend money to key sectors of the economy. For example during economic recession, these financial service providers become reluctant in lending money. In fact borrowing becomes very expensive since they raise their interest rates so as to offset the possible risk of their borrowers not repaying loans. The major reason for doing this is that economy that is in recession not only scares away investors but also leads to dissolution of businesses that may not have enough cash flow to finance their trading activities.
If you have been keen enough in understanding the concepts of working capital and cash flows, then this question must have come into your mind; can the company’s cash flow be affected by changes in its working capital? The answer is yes. The operating cash flow, a subset of the company’s cash flow reflects changes in the short term working capital for example negative working capital means the company has paid out more cash than it brought in when managing the working capital. This analysis is important to companies with seasonal or unpredictable cash flow needs.
Working capital enables a company to know whether it can continue with the business operations or needs to be dissolved. A company requires a positive working capital to be able to go on with its activities. This is due to availability of sufficient funds that can satisfy all the maturing and upcoming expenses. The company’s assets should therefore be readily convertible into cash to avoid sudden dissolution.
Adequate working capital also enables a business to make payments promptly and thus creating and maintaining a goodwill. The goodwill is enhanced as the business is able to pay all its operating expenses and current liabilities on time. Moreover, regular supply of the factors of production like raw materials is ensured for continuous production since suppliers get satisfied by the timely payment.
A firm having sufficient working capital, good credit rating and high solvency can easily borrow loans from financial institutions like banks in favorable terms. This further enables the business to have access to different options for raising cash, hence increasing its cash flow. It also gives the firm enough courage to face crisis in emergencies like depression.
Sufficient working capital and cash flow is therefore the life blood that maintains the business in all conditions. Any daily financial requirement can easily be met without shortage. All current liabilities and expenses are paid with ease and on time.