Working Capital

Description of Working Capital. Explanation.

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Definition Working Capital. Description.

Working Capital is the amount by which current assets exceed current liabilities. It is used to fund the operations of the company, such as purchases of raw materials, office supplies, salaries, etc. More specifically it finances the cash conversion cycle of a business: the number of days required to convert raw materials into finished goods, finished goods into sales, and accounts receivables into cash.

The amount of working capital needed varies with a number of factors, including: type of industry, efficiency of production processes, economies of scale, seasonality, sales success, etc. A (temporary) shortage in the working capital can easily lead to bankruptcy of a small firm, even if it has many profitable orders coming.

Internal sources include: retained earnings, savings through achieving operating efficiencies, allocation of cash through depreciation, deferred taxes.

External sources include: short-term borrowings, trade credit, accounts receivables factoring.

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Recent User Comments

    			 
  			   Jill - USA
  	       
  		     Collection Period
  	  		 "Does a significantly higher average collection period than the industry average suggest poor credit decisions, high profit levels, rapid collection of accounts or low liquidity levels?"
  			   
    	  		 0

    			 
  			   Phani Kumar - India
  	       
  		     Working Capital Management
  	  		 "How can you determine from the balance sheet of any company the firms' liquidity and profitability?"
  			   
    	  		 -1

    			 
  			   Phani Kumar - India
  	       
  		     Marginal Profitability from relaxing Credit Policy
  	  		 "Suppose the annual sales of XYZ Ltd. is Rs. 24,000,000. After 6 months an account is turned over to a collection agency and on average one percent of the total receivable volume under the
present credit policy is never received by the firm. The current policy and the expected effects of two proposed policies, A and B, are compared in following table:

Present Policy / Policy A / Policy B

Additional demand (Percentage) 0 / 25 / 35

Average collection period 1 month / 2 months / 3 months

Default losses (Percentage) 1 / 3 / 6

Determine the marginal profitability from relaxing the credit policy:

- from the present policy to policy A and then from policy A to policy B

- by comparing the marginal profitability to the required rate of return (20%) on additional
investment in receivables."
  			   
    	  		 5

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End of description Working Capital. An explanation.