Banking and Finance
Working capital
What it is and why it’s important for businesses to have
Smart Business Dallas | May 2008
Jorge Calderon
Senior vice president
Commercial market executive
Capital One Bank, Dallas
Oftentimes, the dividing line between
success and failure in business can
be a thin one. A business must be multifaceted and do everything equally
well to ensure its long-term viability. One of
the things it can’t ignore is working capital.
“Working capital is essential for a business to be able to meet its short-term obligations and have liquidity to endure working capital cycles,” says Jorge Calderon,
senior vice president and commercial
market executive of Capital One Bank in
Dallas. “A keen understanding of the different types of working capital goes a long
way toward helping businesses navigate
sometimes choppy financial waters.”
Smart Business spoke with Calderon
about how working capital is defined and
why it’s so important for businesses to
have it.
What is working capital?
The technical definition of working capital is the difference between current
assets and current liabilities. However,
the practical definition is the amount of
capital required to cover day-to-day
expenses and short-term debt obligations:
labor, raw materials, utilities, paying vendors, meeting payroll, rent, principal and
interest payment on debt, etc.
Why is it critical for a business’s operations?
Although the technical definition measures a short-term period, most businesses
must have a minimum level of working
capital to operate over the long haul.
Meeting the short-term obligations and
having the liquidity to endure the working
capital cycles is paramount to the success
of most businesses.
What is the difference between operational
capital and financial capital?
There are two main considerations to
working capital: operational and financial.
Operational working capital considers two
key factors: operating cycle and costs. If
your business has a long operating cycle, your working capital needs will be higher
than a business with a short operating
cycle. The second operational factor is
cost. If your raw material and/or labor
costs are high relative to your total cost,
then you require a higher level of working
capital. High labor or raw material cost
(relative to total cost) combined with a
long operating cycle is a perfect storm for
a higher level of working capital.
Financial working capital considers
your cash collection and disbursement
cycle. In addition to the day-to-day expenses associated with labor and materials, the velocity in which you collect and
disburse cash will significantly affect your
working capital. To start, the most important factor for collection and disbursements is driven by the terms of your sales
and purchases. Consequently, if you collect faster than you disburse, your working capital needs will be minimal.
Conversely, if your collections lag your
disbursements, your working capital
needs will be higher, i.e., if you are paying
your trade and employees faster than
you’re collecting from your customers.
Banks provide an array of products to
alleviate some of these working capital
challenges, like a lockbox, controlled disbursement, and corporate and purchasing
credit cards.
What are some sources of working capital?
There are three main sources of working
capital: customers, trade vendors and
commercial banks. Regarding customers,
in some businesses, requiring a deposit to
start a job is usual and customary.
Regarding trade vendors, your suppliers
can help elongate your disbursement period or step in during seasonal peaks.
Regarding commercial banks, most established businesses have a revolving credit
facility that fluctuates with the business
cycle and provides peace of mind during
any working capital cycle.
What are the reasons businesses fail to
maintain an adequate level of working
capital?
My experience with business owners
and financial officers is that they’re very
astute and nimble in making quick
changes to their business models in order
to capitalize on a business opportunity. At
times, these business opportunities result
in consequences to their working capital
cycle, i.e., prepurchasing materials at a
discount or accepting return items from a
significant customer. Companies with an
active trading cycle, i.e., wholesalers or
retailers, can best gauge their businesses
by the level of working capital. During
high periods, any working-capital-intensive business needs to be very cautious
about changing the velocity of its cash
cycle or committing resources to purchase long-term assets, such as equipment, real estate, etc. It’s best to match
sources and uses of capital — finance
short-term assets with short-term liabilities and long-term assets with long-term
liabilities.
JORGE CALDERON is senior vice president and commercial market executive of Capital One Bank in Dallas. Reach him at (972) 855-3936 or jorge.calderon@capitalonebank.com.
