New announcement. Learn more


Working Capital and Liquidity – Are you under stress?

One size does not fit all when it comes to necessary working capital needs, but the basics are simple.  Every business needs liquidity.  Working capital defines short-term access to cash and liquidity.  Think of it as a buffer zone as to what you have access too, versus what need to pay for.

The working capital of a business is calculated as the Current Assets minus the Current Liabilities.

Current Assets = the sum of Cash in the Bank, Debtors, Stock, WIP, and Prepayments

Current Liabilities =  the sum of Accounts Payable, Creditors, Accruals, Provisions, PAYE, FBT, GST,  Income Tax, Short Term debt, Shareholder current account, OVERDRAFT  / Seasonal Facilities.

Working capital is used to cover all of a company’s short-term expenses, including inventory, payments on short-term debt and operating expenses. Basically, working capital is used to keep a business operating smoothly and meet all its financial obligations within the coming year.

If a business cannot meet its short-term debt obligations, it is experiencing liquidity risk. Well run businesses should have 3 months working capital.

Liquidity describes the degree to which an asset or security can be quickly bought or sold in the market at a price reflecting its intrinsic value.

Cash is universally considered the most liquid asset, while tangible assets, such as real estate, fine art, and collectibles, are all relatively illiquid.

The Liquidity ratio which Banks look at carefully is calculated by dividing the current assets by the current liabilities. It is also called the working capital ratio. A ratio greater than 1 shows that the company expects to receive more cash inflows from receipt of current assets than it expects to pay on account of current liabilities in  the next 12 months. Note this can be measured monthly.

Different industries have different ratios. Airlines and Supermarkets often operate with a ratio less than 1 as they receive payment before provision of service (airline) or paying suppliers = supermarkets.  Many businesses need the ratio to be greater than 2x and bank loan covenants often require it.

Banks often also look at the quick ratio which is a measure of how well a company can meet its short-term financial liabilities. Also known as the acid-test ratio, it can be calculated as follows: (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities. Stock is excluded as often it takes longer than month to realise.  As businesses become impaired or overtrade (grow too fast) running out of cash is what kills them.

Over the last 30 years or more I have been involved in many difficult situations that can be solved by restructuring and refinancing. If you need support or would like an independent assessment of where you are at – please email me or call on 027-262-9596.