Business Finance – Working Capital Notes & Depreciation

Revision notes on working capital and depreciation for A2 Business Studies

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  • Created on: 25-03-08 16:29
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Business Lindsay Emma Rudd
Working Capital
What is Working Capital?
Working capital measures the amount of money available to a business to pay its day to day expenses,
such as bills for fuel and raw materials, wages and business rates. Much attention is given to the
capital firms choose to invest in fixed assets, but of equal importance to the success of the business
is the capital set aside to finance regular transactions. Working capital is what remains of a business's
liquid assets once it has settled all its immediate debts.
It if possible to calculate the working capital of a business from its balance sheet by using the
following formula
In a balance sheet working capital is usually labelled as net current assets.
Too much Working Capital?
It is too simple to argue that a business should hold large amounts of working capital to ensure it can
always pay its debts in the short term and has spare assets in the liquid form (cash and debtors).
Holding excessive amounts of working capital is not wise. The nature of liquid assets such as cash
and creditors mean that they earn little or no return for the business. Therefore a well managed
business will hold sufficient liquid assets to meet its need for working capital, but will avoid having too
many assets in such an unprofitable form.
A number of factors influence the amount of working capital a firm needs to hold.
The volume of sales ­ Obviously a firm with a high level of sales will need to purchase more raw
materials, pay a greater amount of wages and so on. Therefore its need for working capital
would be high.
The amount of Trade Credit offered by a business ­ If a firm offers customers a lengthy period
of time before they are required to pay, this increases a business's requirement for working
capital. In affect companies allowing trade credit offer their customers an interest free loan.
Whether or not the firm is expanding ­ In a period of expansion working capital requirements
are like to rise as the business purchases more fuel and raw materials. If a business expands
without arranging the necessary working capital it is described as overtrading.
The length or the operating cycle ­ The amount of time that elapses between the firm first paying
for raw materials and receiving payment from customers. Some manufacturing industries (e.g.
ship building) have long operating cycles and therefore a greater need for working capital.

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Business Lindsay Emma Rudd
The rate of Inflation ­ When prices rise rapidly, firms will require greater amounts of working
capital to fund the increased cost of wages, components and raw materials.
As a rough guide, a firm holding current (or liquid assets) of twice the value of current liabilities would
normally have sufficient working capital. It is also important for a business to have a sufficient
proportion of its working capital in the form of cash.…read more

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Business Lindsay Emma Rudd
meaning a business's receipts from sales decline dramatically while expenditure is temporally
Poor Credit Control. In a well managed business emphasis is given to monitoring debtors to
ensure that they settle their accounts and that they do so punctually. If a business fails to
operate an effective system of credit control, then the incidence of bad debts may increase
resulting in a loss of revenue for the business.…read more

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Business Lindsay Emma Rudd
Negotiate additional Can provide Can be very costly Firms experiencing
short term loans immediate inflow of May be difficult to short term liquidity
cash arrange in times of problems
Minimal long term a financial crisis
Cut production costs Can improve May lead to Businesses with
profitability and well additional short potential to reduce
as liquidity term costs e.g.…read more

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Business Lindsay Emma Rudd
Acid Test Ratio
This compares the current assets with the current liabilities, but does not include stock, because cash
held in stock is not available straight away.…read more

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Business Lindsay Emma Rudd
Problem = Unexpected Changed in Demand
Solution = Source different suppliers
Sell assets
Problem = Seasonal Factors
Solution = Discount / reduce prices
Sale and leaseback of assets
7…read more


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