The question in the chapter title probably appears simplistic. The answer is obviously to pay for things: suppliers for stock, staff for their wages, utilities for services, the bank for the mortgage on the premises or the landlord, the taxman, the photocopier rental people, the leases on the equipment. And so on, right down to yourself as a business owner since you need a salary, dividends or drawings for the time and effort you put in to running the business, otherwise what is the point?Yet it’s a good question to start with, since it helps to start to illustrate the different uses for cash in your business and how it impacts on the types of finance you need.

Investment And Working Capital

It is when you start to think about what you need cash for in your business that you can see it divides into two different areas.

The first is what you could see as the long-term investment in the business. This can take many forms. It could be investment in physical assets such as machinery, or in buying the business’s factory or offices, or in less tangible things such as research and development in order to produce intellectual property, or in long-term marketing to develop a brand, or even in training in order to develop staff skills and resources.

These can all be seen as long-term investments in the business’s future, which require a long-term commitment of funds to achieve results and where a payback is going to come over many years.

These are in contrast to the shorter-term requirement to finance the day-to-day trading of the business, the buying in of stock and the meeting of the day-to-day running costs of the business, including the cost of staff wages in order to be able to sell goods or services on to customers.

The Working Capital Cycle

This shorter term activity and requirement to make payments actually forms part of a larger cycle of activities in the business which accountants refer to as the working capital cycle. This concept is illustrated in the diagram in Figure 1 of a cash pump which shows how a business’s working capital cycle is like a person’s heart, pumping the business’s lifeblood of cash around its system in a virtuous circle.




Imagine for a moment a business which only undertakes a single transaction at a time, buying in goods and selling them on, and which operates on credit. You can see that starting at the top of the circle the business will buy goods from a supplier (a purchase) at a cost of £75 and in doing so it creates somebody who is owed money, known in accounting terminology as a creditor (it may help you in thinking this through to use the American term of ‘payable’ as this is more descriptive).

The goods that the business has bought then form the business’s stock (at a value of £75, being the price the business has bought them at) until it sells them.

When the business then sells these goods to a customer at £100 it creates somebody who then owes the business money (a debtor in English accounting terminology, a ‘receivable’ in American).

In due course you would expect the debtor to pay the business in order to clear their debt of £100 and this means that the business is then holding cash. As the business has sold the goods for a higher price than it has bought them for from the supplier, the cash received in from the sale is then sufficient to both pay off the supplier (the creditor or payable) and generate a surplus or contribution of £25 which can go firstly towards the costs of running the business known as its overheads, and then once these have all been paid represents profit.

Of course very few businesses only deal in a single transaction at a time. So if you imagine many transactions happening over a period, all at different stages in the cycle, it may be easier to think of this cycle as actually being a pump, spinning round and sucking in cash from your customers as they pay their debts.