This section is from the book "Business Finance", by William Henry Lough. Also available from Amazon: Business Finance, A Practical Study of Financial Management in Private Business Concerns.
This chapter has been devoted, in part, to emphasizing the necessity for providing adequate working capital. The result may be to restrict the investment in fixed forms and thus to limit the output and profit-making possibilities of the business. Such a policy would insure a degree of safety, even in the presence of emergencies, which comes only from the possession of an adequate working capital. The popular impression seems to be that it is absolutely essential for a corporation to possess fixed assets which will enable it to turn out its product, whatever that product may be, and that whatever sum is left over will necessarily have to serve as working capital. There is probably no more dangerous fallacy in the whole range of business thought and action. The fact of the case is that, for most corporations adequate working capital is essential, while adequate fixed capital becomes desirable and necessary only after the success of the business has been fully demonstrated. This last statement is not intended to apply, of course, to those lines of business, particularly transportation and public utilities, in which working capital is not a requisite.
To make the case concrete, let us suppose that a water power company is working out a fully completed project for installing a power plant and for serving manufacturing and public utility enterprises throughout a given district. We will assume that contracts for delivery of all the power that can be produced have already been assured and that the payments on these contracts are to be made monthly in advance. Under these conditions, we have an instance of a corporation which must have an amount of fixed capital that can be closely estimated in advance, and which must be sufficient to enable it to complete its whole installation. It needs no working capital, for the monthly cash receipts will be more than sufficient to meet its monthly outgo.
But let us take, also, the very common case of a corporation which is designed to produce and sell a patented device. Frequently the first step is to raise whatever fixed capital is required in order to build a plant and install equipment. Even though the company may have sufficient working capital, it is more than likely to find out a little later that the device itself, or the methods by which it is made, are not in their final form and much of the fixed capital will be wasted.
A far more sensible procedure in most cases would be to have the device manufactured during the first year or two by some company which will take over the manufacturing contract, and to devote all the available capital to building up a selling plan and selling organization, to financing sales, to establishing the credit of the new corporation, and to installing whatever mechanical or business improvements are called for. That is to say, all the resources at the beginning should be kept in the form of working capital. After the selling problem has been solved and the final form of the product has been determined, it will be time enough to proceed with the erection of a plant. If this procedure were more generally followed, there would be fewer setbacks and failures in business.
A closely related fallacy is the common idea that "more capital" is needed in order to make a business move ahead successfully, whereas the real need, ordinarily, is for a better use of the capital already available, and for a demonstration on a small scale that the enterprise can be made a profit-maker. After that demonstration has been given, it is usually comparatively easy to raise fresh capital.