Working capital is the amount of money a company has to cover is operating needs. There are two types of needs for money in any business. The company has to cover its fixed costs no matter whether it produces anything or not. Those fixed costs include rental of premises and lighting. These are costs the company has to meet to keep in business. Apart from those costs, the company needs money to buy raw materials, to lease machinery and equipment and to pay staff. The circumstances of volume dictate the type of working capital that the company needs.
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Peaks and troughs
Few businesses have constant demand all through the year. Most business experience seasonal demand and peaks and troughs in sales. St Valentine’s Day, Easter and Christmas are boom dates for chocolate manufacturers. Clothing retailers sell more in the January sales, in June before everyone goes off on holiday and in September when the kids go back to school. These cycles are unavoidable and companies get used to the varying demand that their sector experiences and plan for those variable sales volumes.
Business should optimise their return on capital. They should not invest in peak demand because that money will be idle during slack demand. Instead, managers need to identify a trend in demand and pitch their capital at those levels. If a company sees that sales range from 4000 widgets a month to 8000 widgets a month they should call on capital requirements for the underlying need and then smooth out the peaks and troughs with short term finance.
As a company needs to pay its bills, it needs to sell so many units per month to cover its costs. Long-term working capital should be requested at the level of production that covers fixed costs. This does not mean the company should fix capacity at the level of production that covers fixed costs. However, they should build in flexibility to enable the business to expand production during peak demand and scale it back during periods of low demand. The classic solution to this problem is to introduce a night shift in peak periods, enabling the business to get a better return on their investment in plant and machinery.
The peaks and troughs of demand should be treated as an opportunity to smooth financing. Periods of high demand require heavier purchasing of materials, but will lead to greater returns. This is a good application for short-term financing. Rather than using investors’ money to meet these costs businesses should use short-term loans and overdrafts. The cost of materials has to be paid for before sales bring in the cash from the products derived from those materials.
Long-term volumes, particularly throughput needed to cover fixed costs, should be covered by long-term working capital. This is either shareholders’ equity or long-term debt. The extra costs of meeting peak demand should be covered by short-term working capital, which comes from short-term loans, or overdrafts. These get written into the accounts as “current liabilities.”
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