What is working capital?
Working capital represents a net investment in short-term assets. These assets are continually flowing into and out the business and are essential for day-to-day operations. The various elements of working capital are interrelated and can be seen as part of a short-term cycle (McLaney and Atrill, 2010)
To put this another way, working capital is to a company what water is to a plant. If the plant does not have enough water, it will not grow. Eventually, it will wither and die. If the plant receives too much water, it will drown. Just as plants need the right amount of water in order to grow, companies need the right amount of working capital to achieve desired levels of profitability and liquidity. (Cunningham, Nikolai And Bazley,2004)
Working capital management
The control and management of working capital directly influences an organization’s ability to survive. To illustrate this, consider the fact that many organisations that go out of business are profitable. The reason they can no longer function is that that they have run out of cash; if they cannot pay their creditors on time they are not going to receive any further supplies on credit terms. If they cannot get their supplies, they cannot produce their goods and services; if they cannot do this, they have nothing to sell. If they have nothing to sell, their cash position will deteriorate rapidly and everything will soon grind to a halt (Proctor, 2009)
It is to the firm’s advantage to keep the investment in working capital to a minimum but at the same time invest sufficiently in current assets to be able to carry out day-to-day trading activities efficiently. This balance between the cost and the level of working capital must be carefully managed. (Berry and Jarvis, 2006)
Keeping the right amount of working capital requires careful planning and monitoring. So, a company may have excess cash sitting idly in its checking account, or it may need additional short-term financing. (Cunningham, Nikolai And Bazley,2004)
Working capital cycle
In working capital cycle cash operates as a fuel, circulating the business to work with the flow.
The working capital cycle is utilized to determine the time from any investment outlay or investment in current assets to the inflow of cash derived from the investment. (Berry and Jarvis, 2006)
An example of working capital cycle can be depicted as shown
Cash is used to pay trade payables for raw materials, or raw materials are bought for immediate cash settlement. Cash is also spent on labour and other items that turn raw materials into work in progress and, finally, into finished goods. The finished goods are sold to customers either for cash or on credit. In the case of credit customers, there will be a delay before the cash is received from the sales. Receipt of cash completes the cycle.(McLaney and Atrill, 2010)
The following information related to Upholland Ltd’s financial account at the end of 31st May 2011.
Gross Profit 80,000
Capital Employed 600,000
Closing Stock 80,000
Cash Balance (CR) 20,000
In order to analyse the company’s present performance and suggest how it may improve it in the coming year it is necessary to calculate some working capital ratios.
Interpreting financial information can be identified by looking at main areas for investigation of accounting information. The use of ratio analysis in each of these areas is introduced below:
Users of account will want to know how much profit a business has made, and then to compare it with previous periods or with other entities. The absolute level of accounting profit will not be of much help, because it needs to be related to the size of the entity and how much capital is has invested in it. (Dyson, 2006)
A.) Gross Profit Margin
The gross profit margin ratio relates the gross profit of the business to the sales revenue generated for the same period. Gross profit represents the difference between sales revenue and the cost of sales. The ratio is therefore a measure of profitability in buying (or producing) and selling goods before any other expenses are taken into account. As cost of sales represents a major expense for many businesses, a change in this ratio can have a significant effect on the ‘bottom line’. (Atrill,2006)
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