Working capital → the amount of finance available to a business for its day-to-day operations
→ Formula:
→ Working capital = Current assets − Current liabilities
→ Current assets → assets expected to be converted into cash or used within a short period → usually cash, inventory and trade receivables
→ Current liabilities → amounts the business needs to pay within a short period → usually trade payables, overdrafts and short-term debts
→ Example:
→ Current assets = ₹8 lakh
→ Current liabilities = ₹5 lakh
→ Working capital = ₹8 lakh − ₹5 lakh = ₹3 lakh
Importance of Working Capital
→ Working capital is needed to finance → day-to-day business activities
→ It allows a business to pay → wages, suppliers, rent, utilities and other short-term expenses
→ Sufficient working capital → helps the business maintain liquidity
→ Liquidity → the ability of a business to meet its short-term financial obligations when they become due
→ Example: A retailer may have profitable sales but need working capital to purchase inventory before receiving payment from customers
→ Analysis: sufficient working capital → bills can be paid on time → suppliers remain willing to provide goods → operations continue smoothly → lower risk of business failure
→ Evaluation: holding too much working capital may mean that money is unnecessarily tied up in inventory or receivables → reducing the funds available for investment
Working Capital and Cash Flow
→ Working capital and cash flow are closely related → but they are not the same
→ Working capital → measures the difference between current assets and current liabilities at a particular point in time
→ Cash flow → measures the movement of cash into and out of the business over a period
→ A business may have positive working capital but still experience cash-flow problems → for example, if too much money is tied up in inventory or trade receivables
→ Analysis: high inventory + slow customer payments → cash is tied up → less cash available for immediate payments → liquidity pressure may develop
Managing Trade Receivables
→ Trade receivables → customers who owe money to the business because they have purchased goods or services on credit
→ Businesses need to manage trade receivables carefully → because delayed payments can create cash-flow problems
→ Methods of managing trade receivables include →
→ checking customers’ creditworthiness
→ setting credit limits
→ setting payment periods
→ offering discounts for early payment
→ sending reminders
→ charging interest on overdue payments
→ taking legal action when necessary
→ Example: A business gives customers 30 days to pay → it sends reminders before the due date and offers a small discount for customers who pay within 10 days
→ Analysis: faster collection of receivables → cash enters the business sooner → improved liquidity → greater ability to pay suppliers and other expenses
→ Evaluation: offering discounts for early payment can improve cash flow → but reduces the amount received per sale
Problems of Poor Management of Trade Receivables
→ Customers may pay late → reducing cash available to the business
→ Some customers may fail to pay → creating bad debts
→ High levels of receivables → money is tied up outside the business
→ Example: A business makes ₹10 lakh of credit sales but customers delay payment for several months → the business may struggle to pay its own suppliers despite making sales
→ Analysis: slow customer payments → lower cash inflows → difficulty paying short-term liabilities → need for additional finance → increased interest costs
Managing Trade Payables
→ Trade payables → suppliers that the business owes money to because it has purchased goods or services on credit
→ Businesses can manage trade payables by → negotiating longer payment periods, agreeing favourable credit terms and paying invoices on time
→ Example: A business negotiates 60-day payment terms with its suppliers → it can sell some of the inventory before having to pay the supplier
→ Analysis: longer payment period → cash remains in the business for longer → improved working capital → greater ability to meet other short-term expenses
→ Evaluation: delaying payment too much may damage relationships with suppliers → suppliers may refuse future credit or demand immediate payment
Trade Receivables vs Trade Payables
→ Trade receivables → money owed to the business by customers
→ Trade payables → money owed by the business to suppliers
→ Increasing trade receivables → more money is tied up outside the business
→ Increasing trade payables → more money can temporarily remain within the business
→ Example:
→ Customers owe the business ₹5 lakh → trade receivables = ₹5 lakh
→ The business owes suppliers ₹3 lakh → trade payables = ₹3 lakh
→ Effective management of both → helps maintain sufficient working capital and liquidity
Capital Expenditure
→ Capital expenditure (CAPEX) → spending on non-current assets that provide benefits to the business over a long period
→ Examples →
→ purchasing land
→ buying buildings
→ purchasing machinery
→ buying vehicles
→ installing major equipment
→ investing in long-term technology systems
→ Example: A manufacturer spends ₹50 lakh on a new production machine → this is capital expenditure because the machine will be used for several years
→ Analysis: capital expenditure → increases productive capacity → potentially increases output → greater ability to meet demand → potential long-term revenue and profit growth
→ Evaluation: capital expenditure requires significant finance → and the investment may take several years to generate sufficient returns
Revenue Expenditure
→ Revenue expenditure → spending on the day-to-day running of the business or maintaining existing assets
→ Examples →
→ wages and salaries
→ rent
→ electricity
→ advertising
→ insurance
→ raw materials
→ repairs and maintenance
→ office expenses
→ Example: A manufacturer spends ₹50,000 repairing an existing machine → this is revenue expenditure because it relates to maintaining the existing operation rather than purchasing a new long-term asset
→ Analysis: revenue expenditure → allows daily operations to continue → maintains production and service quality → supports sales and revenue generation
Capital Expenditure vs Revenue Expenditure
→ Capital expenditure → purchase or improvement of long-term assets
→ Revenue expenditure → day-to-day operating and maintenance expenses
→ Capital expenditure → provides benefits over several years
→ Revenue expenditure → generally provides benefits over a shorter period
→ Capital expenditure → usually increases or maintains the productive capacity of the business
→ Revenue expenditure → supports the current operation of the business
→ Example:
→ Buying a new delivery van → capital expenditure
→ Paying for fuel and routine servicing of the van → revenue expenditure
Impact on Financial Decisions
→ Businesses need to distinguish between capital and revenue expenditure → because they have different effects on financial planning
→ High capital expenditure → requires significant long-term finance → may increase borrowing and financial risk
→ High revenue expenditure → increases the ongoing costs of operating the business → reducing short-term profit if revenue does not increase sufficiently
→ Analysis: capital investment → higher productive capacity → potential future revenue and profit → but increased initial finance requirement
→ Analysis: excessive revenue expenditure → higher operating costs → lower profit margins → reduced cash available for investment
Analysis
→ effective management of trade receivables → faster collection of customer payments → improved cash inflows → stronger liquidity → reduced need for short-term borrowing
→ negotiating favourable trade payable terms → business has longer to pay suppliers → cash remains available for operations → improved working capital
→ excessive trade receivables → cash tied up with customers → reduced liquidity → possible need for additional finance → higher financing costs
→ excessive trade payables → short-term cash position may improve → but supplier relationships may deteriorate → future credit may be withdrawn
→ sufficient working capital → business can meet short-term obligations → operations continue smoothly → lower risk of financial failure
→ capital expenditure → increased productive capacity → potential long-term growth → but requires substantial finance and may increase financial risk
Evaluation
→ The ideal level of working capital depends on → industry, size of business, length of production process and payment terms
→ A manufacturer may need more working capital than a service business → because it may hold significant levels of raw materials, work in progress and finished goods
→ Too little working capital → liquidity problems and possible business failure
→ Too much working capital → money may be unnecessarily tied up in inventory and receivables → creating an opportunity cost
→ Extending payment periods to suppliers can improve short-term liquidity → but damaging supplier relationships may create longer-term problems
→ Capital expenditure can support growth and efficiency → but should only be undertaken when expected future benefits justify the initial cost
→ Overall → effective working capital management requires a balance → the business needs enough current assets to meet short-term obligations, while avoiding excessive amounts of money being tied up in inventory and trade receivables.