The Importance of Working Capital (Cambridge International IGCSE Business)
Exam board Cambridge International · IGCSEUpdated 2025-06-12
An introduction to working capital
- Working capital is the money that a business has available to fund its day-to-day activities
- It is calculated using the formula
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Current assets include cash, cash equivalents or assets which can be converted to cash within a one year period
- Cash
- Debtors
- Inventories (stock)
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Current liabilities are short-term financial obligations that are usually repayable within one year, or as demanded by creditors
- Creditors
- Short-term loans
- Overdrafts
The importance of working capital
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Working capital is vital to the day-to-day operation of a business
- A lack of working capital often leads to business failure if the business cannot meet its immediate financial obligations
- Cash is the most liquid of a business's current assets and can be used to settle debts immediately
- Stock takes time to be sold and converted to cash to pay debts so is the least liquid current asset
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Effective management of working capital involves careful cash management
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If the finance manager is able to balance the flow of money in and out of the business, then the business is more likely to grow and be successful
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A business can hold too little or too much cash, both of which cause different issues
Problems of a shortage or excess of working capital
| Shortage of working capital | Excess of working capital |
|---|---|
| - Businesses may look to convert debtors and stock into cash as quickly as possible. This may mean they have to sell stock at low prices, reducing revenue - Suppliers may not allow an extension of trade credit terms as the business is seen as too much of a risk - Making use of short-term borrowing options such as overdrafts can improve a businesses working capital situation but relatively high level of interest must be paid | - Holding large amounts of cash may mean missing out on benefits of investing it in fixed assets or investments - This may represent a significant opportunity cost *not being put to work for the business - If a business is holding large amounts of stock, it may incur extra storage costs, and the cash value of the stock could be used for other purposes |
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