Working capital - the essentials

Internal auditors do not need to be accountants. But internal auditors do need to understand working capital. It is a critical component of a company's financial health and operational efficiency. And never more so than during times of economic stress.

Working capital refers to an organisation's short-term assets (such as cash, inventory, accounts receivable) and short-term liabilities (such as accounts payable, short-term loans) that are used to support the day-to-day operations of the business. It represents the funds that it needs to cover its current obligations and to sustain its operations.

Working capital management is crucial to maintain liquidity and profitability. Too little working capital can lead to failure to pay staff and suppliers, miss opportunities, and even bankruptcy. Conversely, too much working capital can reduce profitability and result in a poor return on investment.

The current financial pressures for organisations from increased interest rates, rising inflation and the energy crisis impact the different components of working capital.

• Current Assets: These are assets that are expected to be converted into cash or used up within one year, such as cash, accounts receivable, inventory, and prepaid expenses.
• Current Liabilities: These are obligations that are expected to be settled within one year, such as accounts payable, short-term loans, and accrued expenses.

Internal auditors should also have a basic understanding of the key financial ratios that are commonly used to assess working capital management, including current ratio and quick ratio (or the acid-test). The Chartered Institute offers a quick online training course for less than £100 to learn about accounting ratios.

Assessing the risks associated with working capital management and evaluating the effectiveness of controls cuts across a variety of audits, not simply a standalone audit of working capital management. Internal auditors should always be alert to risks such as inaccurate forecasting, inadequate inventory management, delays in accounts receivable collections, and inefficient accounts payable processes. Internal controls may involve segregation of duties, authorisation and approval processes, monitoring of cash flows, inventory counts, and credit management procedures.

Working capital has a direct impact on a company's cash flow, as changes in working capital affect cash inflows and outflows. Internal auditors should have an appreciation of the current cash flow statement and its impact on operational activities and planned projects in addition to more accounting considerations of investment and financing activities.

The risk of bankruptcy in the private or third sector or a section 114 notice for a local authority is increasingly real in times of economic hardship. Some of the signs of financial distress to be alert to include:

1. Cash flow shortages meaning the organisation cannot cover day to day expenses or pay bills (or employees) on time.
2. High current liabilities, such as accounts payable and short-term loans, compared to its current assets, such as cash and accounts receivable. May indicate that the organisation is relying heavily on short-term debt to fund its operations.
3. Taking on more debt to cover its operating expenses or refinance existing debt, can be a sign of liquidity issues as it may indicate a reliance on borrowing to meet financial obligations.
4. Trend of declining cash reserves (cash on hand and short-term investments) rather than isolated issues can be an indicator of poor cash flow management or inability to generate cash.
5. Consistently delaying payments to its creditors or suppliers can indicate difficulties in meeting its financial obligations on time.
6. Challenges in obtaining credit from lenders or reduction in credit lines are a sign that external parties consider the organisation an increased credit risk – suppliers demanding proforma payments for example.
7. Any sustained operating losses or declining profitability erode the generation of cash.

Good chief finance officers often use this mantra

Sales is vanity  -  Profit is sanity  -  Cash is reality

Cash is the heartbeat of every organisation, in every sector.
Take time to look at the latest management information.
Do your own analysis?

Test the strength of your organisation’s heartbeat.

Check out this insightful article about Auditing Cash Flow Management
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