Working capital

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Working capital is normally defined as the monetary value of current assets less the current liabilities. When the value of the current assets exceed the current liabilities this is known as positive working capital where current assets are funded partly from the current liabilities such as Accounts Payable (Creditors) and bank over drafts and also from long term sources of funds such as bank loans or equity. The term negative working capital arises when current liabilities exceed current assets. In this case current liabilities are funding both current assets and a proportion of long term assets. Working capital management is concerned with the management of business liquidity in order to attain a balance between profitability and risk.

The current ratio is calculated as follows:

Working capital is required to fund the time lag between expenditure being made for the purchase of raw materials and the subsequent collection of cash for the sale of the finished product. This is called the working capital cycle. If a business is operating profitably then it should, in theory, generate cash surpluses. Without cash the business will eventually become insolvent and, therefore, it is widely recognized that the way in which companies manage their optimal cash position can make a difference to shareholder value. There are two major components of the working capital cycle that use cash Inventory and Accounts Receivable (Debtors). The main sources of cash inflow are Accounts Payable and for long term sources Equity and Loans. Each element of working capital has two important dimensions, namely time and money.

Inventory management

Generally a hospitality business should seek to reduce the amount of money tied up in inventories and aim to move inventory stocks more quickly (inventory turnover).

Managing inventories requires specific expertise. Too much inventory held ties up cash in the business but insufficient inventory available can result in lost sales and loss of customer goodwill. To manage inventory effectively it is essential to identify the fast and slow moving stock items within the total inventory and deter mine optimum stock levels. Factors to consider when determining optimum inventory levels include:

  • Accurate projected usage of the product;
  • Frequency and availability of supply; and
  • Relationship between products.

Specific models exist which can help the business to determine optimum stock levels but these are usually dependent on consistent annual demand for products.

Managing accounts receivables

In the hotel sector, in particular, it is necessary to offer credit to customers in order to secure the business. However, slow payment of the outstanding debt can have a serious impact on the business and ultimately can lead to bad debts. An effective debtor policy should include:

  • Clearly established policies for giving credit;
  • Procedures for checking credit worthiness of customers;
  • Established credit limits for each customer;
  • Prompt and accurate invoicing;
  • Penalties for late payment; and
  • Procedures for monitoring outstanding balances.

The monitoring of outstanding payments is commonly undertaken using the accounts receivable ratio.

Debtors due over 90 days should receive immediate attention and are usually clear indicators of future bad debt problems. Increasing debtor days can be an indicator of internal operational problems such as:

  • Poor procedures for collecting debt;
  • Slow issue of invoices and statements;
  • Errors in invoices; and
  • Customer dissatisfaction.

Managing accounts payable

Hospitality businesses can benefit by getting better credit terms from suppliers and increasing short term financing. This is monitored by the accounts payable ratio.

Improved purchasing techniques not only serve to improve the profitability of the business but also improve the liquidity of the business. In the hospitality industry a large proportion of accounts payable arise from the purchase of perishable products such as food and beverages. Effective purchasing includes:

  • Coordination of the purchasing process to achieve maximum discounts and best quality;
  • Accurate forecasting of demand;
  • Understanding of stock holding and purchasing costs;
  • Effective alternative sources of supply; and
  • Knowledge of delivery frequency and availability.

Managing supplier relationships is crucial to managing working capital. Slow payment to suppliers can create bad feeling and undermine the potential to work with suppliers to enhance the future profitability of the business.


Revenue expansion without sufficient working capital can easily over stretch the financial resources of the business. This position is called Overtrading and is a common feature of growth businesses that fail, not because of insufficient product profitability, but due to insufficient liquidity to purchase current assets such as inventories. The working capital ratio measures the relationship between working capital and sales as a percentage.

The faster a company expands in terms of investment, the more working capital it will require. Therefore, a company that borrows long term and invests in short term assets such as cash and stocks is creating liquidity for the business that can create a buffer against risk in times of financial distress. Similarly using cash to purchase long term assets will reduce the liquidity of the business and other forms of longer term financing should be considered such as equity, loans or leasing.


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Dyson, J. R. (1997). Accounting for non-accounting students. London: Pitman Publishing.

Jagels, M., & Coltman, M. (2003). In Hospitality management accounting (8th ed.). New York: Wiley.

Owen, G. (1998). Accounting for hospitality, tourism and leisure. London: Longman.

Schmidgall, R. S. (2002). Hospitality industry managerial accounting (5th ed.). East Lansing, MI: Educational Institute of the American Hotel and Motel Association.

Schmidgall, R. S. (1995). Hospitality industry managerial accounting (3rd ed.). East Lansing, MI: Educational Institute of the American Hotel and Motel Association.

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