ENG ECONOMICS NOTES FOR BTECH EE BRANCH

Working capital definition and example

  Working capital is defined as current assets minus current liabilities. For example, if a company has current assets of $90,000 and its current liabilities are $80,000, the company has working capital of $10,000. Note that working capital is an amount. Some of the factors that determine the amount of working capital needed include:

• Whether or not a company needs to have an inventory of goods
• How fast customers pay for goods or services
• How fast the company must pay its suppliers
• The company's growth rate
• The company's profitability
• The company's ability to get financing

Working capital can be increased by:

• Profitable business operations
• Sale of long-term assets
• Long-term borrowings
• Investment by owners

Working capital can decrease from:

• Unprofitable business operations
• Purchasing long-term assets (without long-term financing)
• Repaying long-term debt
• Distributing cash to owners

Liquidity definition

Liquidity is having the money to pay the company's obligations when they are due. In other words, it is the company's ability to convert its current assets to cash so that the current liabilities can be paid when they come due. Liquidity is necessary for a company to continue its business operations. Liquidity could increase by:

• Increasing working capital (see the above list for increasing working capital)
• Increasing the speed at which current assets are converted to cash
• Delaying the payment of current liabilities
• Delaying the payment of long-term liabilities
• Omitting the distribution of cash to owners

Liquidity could decrease from:

• A decrease in working capital (see the above list for decreasing working capital)
• Purchasing and/or producing too many items for inventory
• A slowdown in the speed at which current assets are converted to cash
• Paying current liabilities too soon

Working capital vs. liquidity

A retailer, distributor or manufacturer may have a large amount of working capital. However, if most of its current assets are in slow-moving inventory, the company may not have the liquidity to pay its obligations on the agreed upon due dates. Similarly, if a company is unable to collect its accounts receivable, it may not have the liquidity to pay its obligations. In contrast, consider a company that sells popular products online and customers pay with bank credit cards or debit cards when they order. Further, the company's suppliers allow the company to pay 60 days after it purchases the products. This company may have very little in working capital, but it may have the liquidity it needs.

Financial ratios and other metrics

There are some financial ratios and metrics that are closely related to working capital and liquidity, such as:

• Amount of working capital
• Current ratio
• Quick ratio
• Accounts receivable turnover ratio
• Average collection period
• Inventory turnover ratio
• Days' sales in inventory
• Cash from operating activities
• Operating cash flow ratio

We will discuss and calculate each of these. We will also point out that if these metrics are calculated by using the amounts from a company's financial statements, the amounts are likely from the prior year. Further, the amounts reported on the financial statements are highly-summarized. Hence, some unusual transactions and amounts will likely be hidden or buried by the enormous number of normal transactions. People within a company will have access to more current amounts and more detailed information that can be sorted, reviewed and analyzed. Therefore, people within a company will gain more insights from the detailed internal information than someone calculating financial ratios by using the amounts reported on the prior year's published financial statements.

Finding the root cause

It is also important to understand the root cause for a change in working capital and/or liquidity. In the case of a liquidity problem, you should "drill down" by asking "Why has liquidity decreased?" You may discover a decrease in the company's accounts receivable turnover rate and an increase in its average collection period. Next ask "Why is there a decrease in the turnover rate and the increase in the average collection period?" You may find that two large customers have slowed their remittances of the amounts they owe. That should lead to another question: "Why is Customer X not paying according to the agreed-upon terms?" The answers could range from the customer is having financial difficulty to the customer is not pleased with the company's products or service. That should lead to yet another "Why?" question. The goal is to get past the symptoms and get to the root cause. Similarly, if the decreases in working capital and/or liquidity are due to unprofitable business operations, a person should also begin a series of "Why?" questions. The answers may lead to an urgent need for an immediate reduction in expenses lest the company is forced to stop operating. Eliminating operating losses is also important for ongoing relationships with lenders, suppliers, customers, employees, owners and more.

Cash is king

"Cash is king" is a popular phrase for several reasons. One reason involves liquidity: cash is necessary to meet Friday's payroll, to make a loan payment, to pay suppliers, to remit payroll taxes, etc. Another reason for "cash is king" pertains to the accrual method of accounting. Under this generally required method of accounting, a company's financial statements will report revenues and the related receivables when they are earned (not when the customers' cash is received). Further, expenses and liabilities are reported when they are incurred (not when the cash is paid out). Because of the judgements used in determining when the revenues and expenses are reported on the income statement, there is a concern with this perceived "flexibility". With cash there are no judgments or estimates involved. The company either has the cash or it doesn't. Fortunately, companies are required to include the statement of cash flows (SCF) whenever its financial statements are distributed. The SCF will report the major cash inflows and cash outflows during the same period as the income statement. The SCF also reconciles the change in a company's cash during the past year. Since liquidity involves cash, you will gain valuable insights by understanding the SCF.

Components of Working Capital

Working capital (also known as net working capital) is defined as current assets minus current liabilities. Therefore, a company with $120,000 of current assets and $90,000 of current liabilities will have $30,000 of working capital. A company with $100,000 of current assets and $100,000 of current liabilities has no working capital. As you can see, working capital is an amount even though it is usually discussed as part of financial ratios.

Current assets

A major component of working capital is current assets. A shortened definition of current assets is: a company's cash plus its other resources that are expected to turn to cash within one year. However, the following is a more complete definition: Current assets include cash (which is not restricted for a long-term purpose) plus the company's other resources that will turn to cash or will be used up within one year (of the date shown in the heading of the balance sheet). However, in the rare situations when a company's normal operating cycle is longer than one year, the length of the operating cycle is used in place of one year for determining a current asset. Examples of current assets (listed in the order they are expected to turn into cash) include:

• cash and cash equivalents
• temporary investments
• accounts receivable
• inventory
• supplies
• prepaid expenses

Current liabilities

The other major component of working capital is current liabilities. A shortened definition of current liabilities is: a company's obligations that will be due within one year. However, a more complete definition is: Current liabilities are a company's obligations (that are the result of a past event) that will be due within one year of the balance sheet's date. However, in the rare situations when a company's normal operating cycle is longer than one year, the length of the operating cycle is used in place of one year for determining a current liability. Examples of current liabilities include:

• loan principal amounts that will be due within one year
• accounts payable
• wages payable
• payroll taxes withheld from employees
• accrued expenses/liabilities (utilities, repairs, interest, etc.)
• customer deposits and deferred revenues

If there is assurance that a current liability will be replaced by a long-term liability, it should be reported as a long-term liability. (The reason is the liability will not be requiring the use of the company's working capital.)

Operating cycle

For a complete understanding of working capital, current assets, and current liabilities, it is necessary to understand the term operating cycle. A company's operating cycle is the average amount of time it takes for the company's cash to be put into the business operations and then make its way back into the company's cash account. To illustrate, let's assume that a distributor of products experiences the following:

1. It uses its cash to purchase inventory items
2. It takes on average 120 days to get the items sold by offering credit terms of 30 days
3. On average, the company receives the money from these customers 45 days after the sales occurred (even though the credit terms were 30 days)

With these conditions, the distributor's operating cycle is on average 165 days, as illustrated here:

hroughout this topic you should assume that the companies we are discussing have:

• operating cycles of less than one year
• insignificant amounts of supplies and prepaid expenses

Reporting Working Capital, Current Assets, Current Liabilities

Working capital

Typically, a company issues a classified balance sheet, which means it has several classifications (or categories) of assets and liabilities. The typical classifications are shown in this condensed balance sheet:

he classified balance sheet allows users to quickly determine the amount of the company's working capital. Using the amounts from the above balance sheet, we have:

  Current Assets = 170,000

Current liability(-)100,000

 Working Capital = 70,000

A company's working capital must be managed so that cash will be available to pay the company's obligations when they come due. This is important for:

• having a positive relationship with creditors, employees, and others
• complying with the terms and conditions in a loan agreement
• maintaining an excellent credit rating

What is fixed capital? Definition and examples

Fixed capital is capital or money that we invest in fixed assets. In other words, money that we invest in assets of a durable nature. These are assets that we repeatedly use over a long period. We can also use the term ‘fixed investment‘ with the same meaning.

Fixed assets are tangible assets that we cannot convert into cash easily. Property is an example of a fixed asset. So are plant and equipment.

We do not resell fixed assets as part of our everyday business operations. We use fixed assets in the production of our company’s income or for administrative purposes.

Some people use the terms fixed assets/capital interchangeably. However, technically, when we use the term ‘capital,’ we refer to the money we invest in fixed assets.

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Fixed capital for businesses

The term includes all the capital investments and assets that we need to start up a business. It also includes all the capital investments and assets we need to conduct business at any stage.

We invest the money in assets that we cannot consume or destroy during the production of a product. We cannot consume or destroy them in the delivery of a service either. Hence, they are ‘fixed assets.’ However, they have a reusable value.

Fixed assets include tangible items we need for business operations. It does not include items we use in the production of something.

For example, equipment and facilities form part of fixed assets. Wood, however, in a furniture factory, is not. We use wood in the production of furniture, i.e., it is a component of an item of furniture.

The term contrasts with circulating capital. Circulating capital includes, for example, raw materials.

Therefore, in furniture a factory, we refer to the building and machinery as fixed assets and the wood as circulating capital.

METHODS OF RAISING CAPITAL or FINANCE

 You have learnt that there are different purposes for which funds have to be raised for periods ranging from very short to fairly long duration. The size and nature of business determine the total amount of financial needs. The scope of raising funds depends on the sources from which flnds may be available. For a sole proprietor, there are limited opportunities for raising funds. He can finance his business by any of the following means:

1 Investment of own savings

2 Raising loans from friends and relatives

3 Arranging advances from commercial banks

 4 Borrowing from finance companie

s The same methods of financing are available to partnership firms also. In both these forms of business organisations, long-term capital is generally provided by the owners, i.e., sole proprietor or the partners. Fixed capital can be raised by way of loans from friends and relatives on the personal security of owners. Generally short-term working capital needs are met partly by trade creditors (suppliers of materials and goods) and loans from finance companies. Another method of securing both long and short-term finance is the reinvestment of profits earned from time to time.

 In the case of companies, there are a number of methods of raising finance. To rais.e long-term and medium-term capital, companies have the following options:

 1 Issue of shares

2 Issue of debentures

3 Loans from financial institutions

4 Loans from commercial banks

5 Public deposits

6 Retention of profits

 The following methods may be used to finance short-term capital:

I Trade credit

 2 Factoring

3 Discounting bills of exchange

4 Bank overdraft and cash credit

 5 Public deposits