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What is working capital?

Short term financial planning involves considering and answering questions such as the following:

• What level of cash needs to be on call at various dates during the next planning period?
• What level of inventory do we need to maintain?
• How quickly can we pay off the bank overdraft?
• What period of credit do we grant to our debtors?
• Should we pay our suppliers quickly and take advantage of the cash discount being offered?
• What proportion of current assets should be financed by short term funds?
• What is working capital and what influences its level?

Short term financial planning is concerned with what is referred to as working capital. Working capital can be defined as the excess of current assets over current liabilities. It is the same as net current assets. It represents the investment of a company's funds in assets which are expected to be realised within a relatively short period of time. It is not an investment in an asset with a long life but, as the name implies, represents funds which are continually in use and are turned over many times in a year. It is capital used to finance production, to support levels of stock and to provide credit for customers. The three main current assets are stock, debtors and cash. They can be funded by short term finance, i.e. current liabilities. Or by medium and long term finance in case of permanent current assets or core current assets.

Permanent working capital and variable working capital:

Permanent working capital: These funds represent the current assets required on a continuing basis over the entire year. It represents the amount of cash, receivables and inventory maintained as a minimum, to carry on operations at any time, as a safety measure.

Variable working capital: These funds represent additional assets required at different times during the operating year. Added inventory must be maintained to support the peak selling periods. Receivables increase and must be financed following periods of high sales. Extra cash may be needed to pay the increased supplies preceding high activity.