What is working capital and what are the difference types?

Working capital is the day-to-day money used by the company to run the business. Working capital is variable because it fluctuates continually as stock is bought and sold, customers pay, wage costs and suppliers are paid, and so on.

Unhelpfully, the term ‘working capital’ is frequently used to mean two different things and often the meanings are used interchangeably.

• On the one hand, working capital is defined as current assets minus current liabilities. Or to put it another way, what is in stock, plus what you’re owed by customers, less what you owe suppliers and HMRC
• The other meaning of working capital is the amount of cash the business needs to have access to in order to meet its day-to-day requirements and fluctuations in payments and receipts.

Of course these two things are related, because the more stock you are holding and debtors and creditors outstanding, (‘asset working capital’) generally the more ‘cash working capital’ will be needed to manage it.

Which version of working capital are we talking about here?

For clarity, let’s think about the cash kind of working capital, i.e. what you need to have access to in order to run your operations on a day-to-day basis.

It is well-known that a large proportion of new companies fail in their first few years of trading, and the same applies to mature businesses too.

Sometimes it’s due to losses being made, where the amount being earned doesn’t cover costs.  However, there are many apparently profitable businesses that fail too, so what is going on there?

That is the difference between fixed capital and (variable) working capital.  A business can potentially survive some losses for a period, until its fixed capital runs out.

Running out of working capital however can finish a business instantly, even if its accounts show a profit.

As the saying goes: ‘Cash is King’.  And just because it’s a cliché, it doesn’t mean it isn’t true.

If you add-up all of your outstanding supplier invoices, rent, direct debits, the wages you will need to pay at the end of the month, the PAYE/NIC and the VAT, then these will be your working capital payments for the month.

One of the great innovations in recent years with the advent of cloud accounting apps is that there are now products which can do this for you and predict your cash position.

Ideally, you would want the comfort of knowing you have the money in the bank to pay all of these.

Of course, the outgoings are only part of the story because you will be receiving income from your customers daily, that can be used to cover the outgoings. Assuming your business is making a profit, the incomings ought to be bigger than the outgoings.

Maybe therefore, you don’t need to have money in the bank all of the time to cover the next month’s outgoings, if you can rely on income to come in before money has to go out. In that case, you probably only need enough ‘working capital’ cash in the bank to cover the days when the larger payments go out and cause a downward spike in cash.

That is a marginal game though. Not many businesses have such consistent income streams that they can run working capital so thinly. And what happens if for whatever reason, not enough money comes in before payments need to go out?

It’s prudent to maintain a buffer to deal with these fluctuations.

In the above example, we were just talking about cash income and outgoings, but it’s usually more complicated than that.

Usually what you buy and sell doesn’t all match on the same day. Most businesses have to hold stock or work in progress [WIP] for services, where you have to pay for things before you sell them.  If you have stock left over when it comes to paying your outgoings, then you need cash to fund both.

We have also assumed so far that customers are paying as they buy, but that is not the case in many businesses, because customers expect to buy on credit.  Therefore not only are you funding the things you haven’t yet sold, you are potentially paying your outgoings before getting any money for the things you have sold.  So now you need cash to fund that as well.

The assets in ‘asset working capital’ should turn into cash in the future when stock is sold and debtors pay, but until then, they are actually a drain on your cash – they are money tied up.

Helpfully, it’s not all one way, because the other component of ‘asset working capital’ is the liability side, creditors.  Namely, that suppliers will advance trade credit also, so they don’t need to be paid until later, by which time you hope to have the money from your customer.

A ‘liability’ sounds like a ‘bad thing’, and it is in the sense that it’s money you owe and therefore will turn into a cash outflow.  However, looked at the other way, it’s cash you have not yet paid and it serves to offset the cash tied up in the stock and debtor assets – your suppliers are effectively providing your business with funding.

What this means is that stock and debtors tie up your cash, and your creditors help to fund it.  Therefore, your business needs ‘cash working capital’ to at least fund the net of ‘asset working capital’ items (i.e. stock plus debtors minus creditors).

So far we have learned that working capital assets (stock and debtors) tie up your cash.  So although we all think of an asset as a ‘good thing’, that isn’t necessarily the case when it comes to business cash flow.

We have also learned that creditors, which are a liability (and conventionally therefore a ‘bad thing’) turn out to be a source of funding and therefore can be good for cash working capital.

Growth must be a ‘good thing’, right?

Well yes, growth is good, but not for cash working capital!

This is because growing usually means holding more stock (cash tied up) and waiting for more customers to pay more invoices (cash tied up). Therefore growing means a business needs to have more cash available to fund these assets.

If the build-up of this working capital commitment exceeds the cash working capital that a business has available, then growth can actually cause failure.  This is known as ‘over-trading’ because the level of activity has gone beyond the business’ ability to fund it. Usually, this will first manifest itself in the realisation that the cash which should have been held back to pay the quarter’s VAT bill has been used up. From there on, it’s a slippery slope.

Initially, cash working capital is drawn from your fixed capital investment of shares and/or borrowing and this is how businesses get started with trading.

If the business is trading profitably and growing at a sustainable rate, then it will begin to accumulate more cash which will enable working capital to be built up.  The key word here is sustainable – remember that growing too quickly can lead to over-trading.

Then there are external sources of cash working capital, the most common being the bank overdraft and invoice finance.

Most people are familiar with the concept of an overdraft, it’s the facility to allow the bank balance to go negative.  An overdraft has the appeal of being simple and it moves with every transaction, so beyond the annual arrangement fee, you only pay interest on the money you are using.

Invoice finance is perhaps less widely understood.  In essence, the lender advances a percentage of your trade debtors, often 80+% of the invoice, enabling you to use the money whilst you are waiting for the customer to pay.  You then receive the balance of the invoice, less the finance charge, when the customer’s money comes in.  One of the attractions of an invoice finance facility is that it grows with you, since more sales give rise to more invoices and thereby more finance. It’s therefore very helpful for growing businesses.

But importantly, let us not imagine that you have to passively react to whatever your asset working capital balance happens to be. It can be actively managed!

Active and effective credit control can help to prevent the trade debtors amount building up beyond what is sustainable. In many types of business, customers may actually welcome being able to pay by standing order instalment or direct debit, to help manage their cashflow and remove the hassle of having to sort the payment at the end of the month.

Similarly stock – it doesn’t control itself.  You can manage it.  Analyse your sales, stock movements and lead times to work out what you actually need to hold. Holding more stock than you need is unnecessarily tying up more cash than you could be.  Holding more perishable stock than you need is wasting money that will never turn back into cash.

Even the best laid plans to manage your asset and cash working capital can suffer unexpected setbacks.  A customer going bust owing you money would be one example. Theft of stock, or fraud on your cash can also adversely impact it. These risks can be managed and controlled though.

Unexpected expenses can arise, for example breakdowns in machines or vehicles and repairs to buildings. Staff sickness requiring agency cover, or leavers resulting in recruitment fees can all be a drain on money needed for cash working capital.

Therefore it is unwise to run working capital too finely or at the overdraft limit – you need to have a buffer for the unexpected.

Avoidable mistakes can arise from failing to properly understand your cash working capital needs.  If there is money in the bank (or unused overdraft), then do you know how much of it is necessary for cash working capital and how much is ‘free’ cash.

Free cash can be used to invest in fixed assets, pay down borrowing or be distributed to owners as dividends.

However, if the real cash working capital requirement is not understood, then the cash you are using might not actually be free and using it in any of these ways could result in struggling to meet your outgoings.

In order to answer this question, you will first need to review both your operating and selling cycles by understanding when sales will happen, what your day-to-day costs are, and what the time gap will be between invoices going out and cash coming in.

If your calculations are based on your historic sales, this may be a relatively easy thing to work out. But in many businesses (particularly in a growth or start-up phase), there can be a lot of initial guesswork involved.

This is where it can be useful to have the support of an adviser to help analyse your working capital needs and to prepare a cash flow forecast.  Your accountant can also help you to create management accounts to monitor the amount of working capital your business has on a monthly or weekly basis and your progress against your cash flow forecast.

As you can see it’s important to try to understand how the working capital cycle works in your business and to seek guidance early if the underlying financial trends indicate that your working capital is beginning to come under pressure.

For further information please get in touch with us.