Working Capital: Everything You Need to Know

1. What is Working Capital?

Working capital is the money a business uses to pay its short-term expenses and keep
operations running smoothly. It shows whether a company has enough assets to cover its short-
term liabilities (bills and debts).

Formula:
Net Working Capital (NWC)=Current Assets−Current Liabilities\text{Net Working Capital
(NWC)} = \text{Current Assets} - \text{Current Liabilities}

• Current Assets: Cash, accounts receivable (money customers owe), inventory, and
short-term investments.
• Current Liabilities: Accounts payable (bills owed), salaries, short-term loans, and
taxes due.

Example:
If a company has $100,000 in assets and $60,000 in liabilities, its NWC is:

100,000−60,000=40,000100,000 - 60,000 = 40,000

Since NWC is positive ($40,000), the company can easily pay its short-term debts.

2. Types of Net Working Capital

A. Positive Net Working Capital (Financially Healthy)

• Meaning: The company has more current assets than liabilities.

• Impact: It can pay its bills easily and has extra cash for expansion or emergencies.

Example:
A company has:

• $150,000 in current assets

• $80,000 in current liabilities

150,000−80,000=70,000150,000 - 80,000 = 70,000

Since NWC is positive ($70,000), the company is in a good financial position.

B. Negative Net Working Capital (Financial Risk)

• Meaning: The company has more current liabilities than assets.

• Impact: It may struggle to pay bills, rely on loans, or sell assets to cover costs.

Example:
A company has:

• $50,000 in current assets

• $80,000 in current liabilities

50,000−80,000=−30,00050,000 - 80,000 = -30,000

Since NWC is negative ($-30,000), the company may face a cash shortage.

C. Zero Net Working Capital (Break-even Point)

• Meaning: Current assets and liabilities are equal.

• Impact: The company can pay its bills but has no extra cash for growth.

Example:
A company has:

• $70,000 in current assets

• $70,000 in current liabilities

70,000−70,000=070,000 - 70,000 = 0

Since NWC is zero, the company is stable but has no financial cushion.

3. Importance of Working Capital Management

Managing working capital effectively helps a company:

Pay bills on time
Avoid borrowing too much money
Keep cash available for growth
Reduce financial stress
If a business mismanages working capital, it may:
Struggle to pay expenses
Face high-interest debt
Lose customer trust
Risk bankruptcy

4. Components of Working Capital

A. Current Assets (Short-term Resources)

1. Cash: Money available immediately.

2. Accounts Receivable: Money owed by customers.
3. Inventory: Goods ready for sale.
4. Short-term Investments: Stocks or bonds that can be quickly converted to cash.

Example:
A store has:

• $20,000 in cash
• $40,000 in unpaid customer bills
• $50,000 in unsold goods

Total Current Assets = $110,000

B. Current Liabilities (Short-term Obligations)

1. Accounts Payable: Bills the company owes to suppliers.

2. Short-term Loans: Money borrowed for immediate use.
3. Salaries Payable: Wages owed to employees.
4. Taxes Payable: Government taxes due soon.

Example:
A business owes:

• $30,000 to suppliers
• $20,000 in employee salaries
• $10,000 in short-term loans

Total Current Liabilities = $60,000

5. Working Capital Cycle (Cash Conversion Cycle - CCC)

The cash conversion cycle (CCC) measures how long a company takes to turn inventory into
cash.

Formula:
CCC=Inventory Days+Receivable Days−Payable DaysCCC = \text{Inventory Days} +
\text{Receivable Days} - \text{Payable Days}

• Inventory Days: Time to sell goods.

• Receivable Days: Time to collect customer payments.
• Payable Days: Time to pay suppliers.

Example:
A company:

• Sells inventory in 40 days

• Collects payments in 30 days
• Pays suppliers in 50 days

CCC=40+30−50=20 daysCCC = 40 + 30 - 50 = 20 \text{ days}

A shorter CCC is better because cash is received faster.

6. How to Improve Working Capital

A. Speed Up Cash Collection (Receivables Management)

Offer discounts for early payments

Send payment reminders
Reduce credit period for customers

Example:
A store gives a 2% discount if customers pay within 10 days instead of 30 days. This speeds up
cash flow.

B. Manage Inventory Efficiently

Use Just-in-Time (JIT) to reduce excess stock

Avoid overstocking or stockouts
Example:
A bakery buys fresh ingredients daily instead of storing them for a month, reducing waste and
saving money.

C. Delay Payments (Payables Management)

Use full supplier credit period

Negotiate longer payment terms

Example:
A retailer gets 60 days to pay suppliers but sells products in 30 days, keeping cash for longer.

7. Trade-off Between Profitability and Risk

A business must balance profitability (higher sales) and risk (having enough cash).

• High Working Capital → Safe but lower profits (cash not invested).
• Low Working Capital → Risky but higher profits (more money invested in growth).

Example:

• A restaurant keeps extra food stock → Less risk, but higher storage costs.
• A tech company invests cash in new projects → Higher risk, but potential high
returns.

Is Zero Net Working Capital a Positive Reality?

Zero Net Working Capital (NWC) means that a company's current assets (cash, inventory,
receivables) are equal to its current liabilities (bills, salaries, short-term loans).

NWC=Current Assets−Current Liabilities=0NWC = \text{Current Assets} - \text{Current

Liabilities} = 0

But is this a good or bad situation? The answer depends on the type of business and industry.
1. When Zero NWC is a Positive Reality (Efficient Business Model)

Some businesses operate efficiently with zero NWC because they can quickly turn inventory
into cash and use that cash to pay bills just in time.

Examples of Positive Zero NWC Businesses:

Retail & Supermarkets: They sell products daily and use that money to pay suppliers.
E-commerce Platforms: Companies like Amazon receive customer payments before paying
suppliers.
Fast-moving Consumer Goods (FMCG): Businesses like Coca-Cola operate with minimal
working capital because they sell products quickly.

Why it Works Well?

• Money is not locked in excess inventory.

• Less need for borrowing, reducing interest costs.
• Cash flow is predictable and stable.

Example:
A supermarket sells groceries every day and pays suppliers every month. If it collects payments
before paying suppliers, its working capital stays near zero but cash flow remains strong.

2. When Zero NWC is a Problem (Financial Risk)

If a business does not generate cash quickly or relies too much on credit, having zero NWC can
be risky.

Examples of Businesses Where Zero NWC is Risky:

Manufacturing Companies: Need to buy raw materials before selling products.

Construction Firms: Large projects require upfront investment.
Seasonal Businesses: Like holiday gift shops, which may need extra cash in peak seasons.

Risks of Zero NWC:

• No cash buffer for unexpected expenses.

• Delayed customer payments can lead to cash shortages.
• Economic downturns can cause financial distress.
 Example:
A car manufacturer pays suppliers upfront but customers take 3 months to pay. If working
capital is zero, any delay in customer payments could cause cash flow problems.

Conclusion: Zero NWC – Good or Bad?

Good if a business has fast cash flow and low inventory needs (like retail).
Risky if a business needs big investments upfront or has slow-paying customers (like
manufacturing).

The best approach is to have a balance: keeping working capital low but not zero, ensuring
enough cash to handle unexpected costs.

Trade-off Between Risk and Return

The trade-off between risk and return means that businesses and investors must balance
potential profits (return) with the possibility of losses (risk). The higher the risk, the higher
the potential return, and vice versa.

1. Understanding Risk and Return

• Risk: The chance of losing money or failing to achieve expected profits.

• Return: The profit earned from an investment or business decision.

Key Principle:

"Higher risk = Higher potential return"

"Lower risk = Lower potential return"

Example:

• Stock Market Investment (High Risk, High Return): A person invests in new tech
startups with high growth potential but also high failure risk. If successful, they
could double their money, but if the company fails, they could lose everything.
• Bank Savings Account (Low Risk, Low Return): A person deposits money in a fixed
deposit account with a guaranteed small interest rate but no risk of losing
money.
2. Trade-off in Business: Profitability vs. Safety

Businesses also face a trade-off between taking risks to grow profits and playing it safe to
avoid losses.

Situation Higher Risk, Higher Return Lower Risk, Lower Return

Investment in New Launching a new product (can Sticking to old products (less
Projects succeed or fail) growth, safe profits)

Inventory Buying in bulk (lower cost, risk of Keeping less stock (avoids
Management unsold stock) excess inventory, risk of shortage)

Giving loans to customers Only cash sales (safe but lower

Credit Policy
(higher sales, risk of bad debts) sales)

Taking loans for expansion Using own funds (safe, but slow
Borrowing Money
(growth potential, high debt) growth)

Example:
A clothing brand can either:

1. Launch a new fashion line (high risk, but high return if successful).
2. Continue selling old styles (low risk, but limited growth).

3. Managing the Trade-off: How Businesses Balance Risk and Return

Diversification – Investing in different areas to reduce overall risk.

Risk Analysis – Studying market trends before making big decisions.
Gradual Expansion – Growing step by step instead of taking huge risks at once.
Financial Planning – Keeping enough cash reserves to handle unexpected losses.

Example:
A restaurant chain expands by opening one new outlet at a time, instead of launching 10
outlets at once, reducing risk while still growing.
Working Capital Financing Policies
A company's working capital financing policy determines how it funds its current assets
(cash, inventory, receivables). There are three main approaches:

1. Aggressive Policy (High Risk, High Return)

2. Moderate Policy (Balanced Risk & Return)
3. Conservative Policy (Low Risk, Low Return)

1. Aggressive Working Capital Policy (🔴 High Risk, High Return)

What is it?

• The company relies more on short-term financing (like bank overdrafts, trade
credit).
• Keeps lower cash reserves and low inventory levels to reduce costs.

Advantages ✅

Lower financing costs (short-term loans have lower interest than long-term loans).
Higher return on investment because cash is not sitting idle.

Disadvantages ❌

Higher financial risk – If cash flow problems arise, the company may struggle to pay debts.
More pressure to sell quickly – The company must turn inventory into cash fast.

Example:

A smartphone company orders only a small stock of phones to avoid high storage costs. If
demand suddenly increases, they may run out of stock and lose sales.

2. Moderate Working Capital Policy (🟡 Balanced Risk & Return)

What is it?

• The company balances short-term and long-term financing.

 • Keeps a reasonable amount of cash and inventory for flexibility.

Advantages ✅

Lower risk than aggressive policy – Enough reserves to handle unexpected expenses.
Flexible financing – Uses both short-term and long-term funds.

Disadvantages ❌

Moderate financing cost – Not as cheap as an aggressive policy.

May not maximize profits – Some cash may be unused.

Example:

A clothing brand keeps a mix of seasonal and long-term stock, so they can adjust to changes
in fashion trends without running out of cash.

3. Conservative Working Capital Policy (🟢 Low Risk, Low Return)

What is it?

• The company relies more on long-term financing (like long-term loans or equity).
• Keeps high levels of cash and inventory for safety.

Advantages ✅

Very low risk – The company always has cash to pay expenses.
No risk of stock outs – High inventory means customers always get products.

Disadvantages ❌

Higher financing cost – Long-term loans have higher interest rates.

Lower profits – Too much cash sitting idle means less investment in growth.

Example:

A supermarket chain keeps large inventory stocks and extra cash to avoid running out of
goods, even if it means paying higher storage costs.
Comparison Table
Inventory &
Policy Risk Return Financing Best for
Cash Reserves

Mostly short-term Fast-growing

Aggressive High High Low
loans businesses

Mix of short-term & Balanced

Moderate Medium
Medium Moderate long-term loans approach

Mostly long-term Stable

Conservative Low Low High
loans businesses

Which Working Capital Financing Policy is the Best?

There is no single “best” policy for all businesses. The choice between aggressive, moderate,
and conservative policies depends on business size, industry, financial stability, and risk
tolerance.

1. Best Policy Based on Business Needs

Business Type Best Policy Reason

Fast-growing startups (Tech, E-commerce, Need quick cash flow, focus

Aggressive
Fashion, etc.) on high returns.

Manufacturing companies (Cars, Need stable cash for

Moderate
Electronics, Heavy Industry, etc.) inventory, not too risky.

Stable businesses (Supermarkets, Need financial security, can

Conservative
Pharmaceuticals, Banks, etc.) afford higher reserves.

Example:

• Amazon (Aggressive Policy): Relies on fast inventory turnover and short-term

financing.
 • Toyota (Moderate Policy): Balances inventory and financing risks.
• Walmart (Conservative Policy): Maintains high cash reserves to ensure stability.

2. Best Policy Based on Market Conditions

Market Condition Best Policy Why?

Economic Growth (Boom Aggressive or Businesses take risks to maximize

Period) Moderate profits.

Stable Economy Moderate Companies balance risk and return.

Firms prioritize survival over high

Recession or Uncertainty Conservative
returns.

Example:

• During COVID-19, many businesses shifted to a conservative policy to ensure

liquidity.
• In booming economies, companies take more risks to grow faster.

3. Final Recommendation: Moderate Policy is the Best for Most

Businesses

Balances risk and return

Uses both short-term and long-term financing
Provides enough cash reserves without excess

When to Use an Aggressive Policy?

When a company wants fast growth and can handle financial risk.
Example: Startups, e-commerce businesses, tech companies.

When to Use a Conservative Policy?

When a company wants financial stability over high profits.
Example: Banks, supermarkets, pharmaceuticals.
Conclusion: No "One-Size-Fits-All" Policy

• Moderate policy is best for most companies as it provides a balance.

• Aggressive policy works for high-growth businesses willing to take risks.
• Conservative policy is best for stable, low-risk businesses.

The best policy depends on a company’s growth strategy, industry, and economic conditions.