Understanding Financial Terms

Safal Niveshak  - http://www.safalniveshak.com/smart-people-investing-know-the-language-of-business/#3

Free Cash Flow - http://learnstockmarketbasics.blogspot.in/2012/06/free-cash-flow.html

Stock Market Terms - http://www.valuepickr.com/basics/stock-market-glossary/stock-market-terms  

 

Understanding working capital

Everybody is familiar with the concept of having enough money in their bank to pay the bills at the end of the month.

Working capital works on much the same principle. The process of financial management i.e. Measuring and controlling your level of working capital, ensures your business can function from day to day and have enough current assets (money) to pay your current liabilities (bills).

How is working capital calculated?

Working Capital = Current Assets – Current Liabilities

This is also sometimes called “Net Working Capital”. The figure can be positive, negative, or zero.

Generally, a positive figure is seen as good. If the current assets exactly equal the liabilities the business has no reserves to meet unexpected events like repairs, stock problems, staff recruitment, etc, etc.

Current Assets

Current assets include anything that is able to be converted into money within 12 months

Some examples of current assets are:

•  Cash and equivalents
•  Receivables (money that a company has to receive from its customers for the goods or services that have already been sold)
•  Inventories (goods that the company has produced but are waiting to be sold, or raw materials and semi-finished goods that the company holds in its stock)

Current Liabilities

On the other side, i.e., on the liability side of the balance sheet lie ‘current liabilities’ that represent the amount a company owes to its vendors who have supplied it with raw materials to semi-finished goods, and are waiting to be paid within 12months. Such vendors are known as creditors of the company. Apart from creditors, all the debts of the company that will be repaid within one year are classified under current liabilities.

Some examples include:

• Rents / Mortgages / Raw Materials costs
• Wages
• Utility bills
• Bank Interest on loans
• Taxes

The Importance of working capital

Working capital is a consideration of major importance in determining the financial strength of a manufacturing company. This is because the study of working capital results in knowing whether the company is in a position to carry on its normal day-to-day business comfortably without any financial constraints.

Shortage of working capital (when current assets that can be converted to cash and not enough to cover current liabilities that must be paid out soon) results in slow payment of bills.

A business may be profitable but is at risk of failing if the working capital is not managed correctly.

Many new businesses often fail due to working capital problems. Working Capital can be seen as the lifeblood of business,

the oil that keeps the machine running.

The options open to businesses for increasing the level of working capital include:

Obtaining / increasing an overdraft (A draft in excess of the credit balance)

This is one of the most common methods of improving working capital and the least costly.

Most banks offer competitive overdraft rates and overdrafts are quick to set up and easy to manage.

Short-term Loan

A bank may well agree to a short-term loan (of less than one year duration) to provide temporary financing.

Note that the interest on the loan will become a new current liability.

Factoring

Factoring is a type of lending where an external company will advance the business money against the value of the outstanding invoices. The factoring company charges a service fee and interest on the value of the outstanding invoices. Factoring typically appeals to small businesses. An “in-house” solution is to reduce the time it takes customers who owe the business money (debtors) to settle their account. Both methods improve working capital,

Trade Creditors

Working capital is improved by lengthening the time creditors are paid. Rather than paying trade creditor invoices immediately, a business can improve working capital by waiting until they actually fall due. Also, it might be possible to re-negotiate credit terms, such as moving from 30 days to 60 days for repayment, or to a “sale or return” policy.

Equity

For many small businesses, equity is a popular way of improving working capital. Entrepreneurs may invest their own funds, or those of family members or friends into the business. Some companies (like internet-start-ups in particular) will use venture capital funds. Once a business is established, a share- issue or reducing the share dividend are two common methods of improving working capital.