When you start your business some of the language used to describe aspects of the financial operations can be mystifying to say the least. In this occasional series, our advisors explain some of the concepts – and language – that is used to give you a clearer understanding.

This week, Gordon Stuart gets to the bottom of working capital and what it means for a business owner. 

Put simply, working capital is used to cover all a company’s short-term expenses, including inventory, payments on short-term debt and operating expenses such as wages, salaries, rent and other overheads. Working capital oils the wheels and is used to keep a business operating smoothly in order to meet all its financial obligations within the coming year.

  • Working Capital is defined as current assets minus current liabilities and, if a business cannot meet its short-term debt obligations, it is experiencing liquidity risk. Running out of cash is what kills any business first.
  • Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value.
  • Cash is universally considered the most liquid asset, while tangible assets, such as real estate, fine art, and collectibles, are all considered relatively liquid.

Understanding your business’s working capital requirements and where your cash is absorbed is key to success when you approach a bank for support.

The first thing a bank looks at is:

The cause (where money has gone) and the purpose of your proposal.

What proportion is being provided by the bank, the business and other participants (e.g. second tier lenders, or asset financiers).

The intended use by the business e.g. to increase working capital to fund growth or to fund an acquisition.

Some questions you need to be able to answer include:

  • What is the length of your operating or cashflow conversion cycle? For example, an importing retailer needs to know how long it takes to get cash from retail sales from the time they source or pay for imports – often more than 3 months. Likewise many service providers do the work but don’t get paid for 30 – 60 days. More importantly do you know how to change the length of the operating cycle or identify ways to unlock cash to improve working capital or support growth?
  • What are your intra and inter month working capital requirements? Banks look at your daily and monthly highs and lows of your overdraft as an early warning signal of trouble.
  • How does productivity and seasonality impact your cashflows? For example – holidays and short months reduce labour productivity which usually has a negative cash impact, alternatively increasing production to build stock for the peak summer season absorbs cash.
  • How many months working capital do you have if you incur losses?
  • Do you have access to an injection of cash if needed?

If you are struggling to understand some of the principles or, like many business owners are learning as you go, don’t be afraid to ask for help – we’re here to do just that.

The Alternative Board - OwnersAuckland CentralWhat is working capital?