It is pretty evident that a lack of operating capital leads to a business’s downfall. How well a business manages its working capital determines its performance and success rates. The management of current assets and current liabilities falls under working capital management.
Working capital management is a business approach for ensuring that an organization works efficiently by monitoring and maximizing the use of its current assets and current liabilities. In simple terms, it refers to a business’s operations to ensure that it has adequate resources for day-to-day operational expenses while maintaining resources invested productively.
The importance of managing a business’s working capital is due to the linkages between different components of working capital. They purchase stock on credit from suppliers. Then, they sell the completed product occasionally on credit as well. Henceforth, this creates accounts payable and accounts receivable. Here, there is a definite rotation of funds, also amongst the capital investment of the company.
Working capital management ensures that the net operating cycle, also known as the cash conversion cycle, runs smoothly. This is the time it takes to transform net current assets and liabilities into enough cash in the shortest possible time.
Working capital management, or the efficient use of a company’s assets, can improve its cash flow management, debt management, and the company’s earnings quality. Inventory management, as well as accounts receivable and accounts payable management, are all included.
The timing of accounts payable is also part of the management of working capital (i.e., paying suppliers). Assuring that the firm has sufficient resources for its ordinary operations implies safeguarding the business’s survival and guaranteeing that it can continue to operate as a going concern. Due to a lack of liquid assets, enough cash, cash flow, uncontrolled credit terms, or not unlimited access to short-term assets, a business may have to undergo restructuring, liquidate or even sell assets.
The inability to satisfy short-term obligations as they become due cause many seemingly prosperous enterprises to go down. Working capital management is critical to a business’s long-term survival.
Because of the potential for interactions between its components, working capital management necessitates extreme caution. Extending the credit duration extended to clients, for example, can result in more sales. However, due to the prolonged wait for clients to pay, the business’s financial position would deteriorate, potentially necessitating a bank overdraft. The interest on the overdraft may potentially outweigh the profit from the extra sales, especially if there is a rise in the number of bad debts.
Because of the reasons listed below, working capital management is critical to the proper operation of a business:
● A company’s current assets make up the majority of its total assets.
● Shareholder wealth links more directly with the cash generation than accounting earnings.
● A key cause of corporate failure is a failure to manage the company’s liquidity.
● Maintain sufficient cash flow.
The current ratio, also known as the working capital ratio, is equal to current assets divided by current liabilities. It is a key metric of a company’s financial health since it demonstrates how well it can meet short-term financial obligations.
Working capital ratios of less than 1.0 shows that a business is having difficulty meeting its short-term obligations. That is, the business’s debts due in the following year would be inadequate to meet them. In this instance, the business may have to sell asset investments, secure long-term loans, or seek other forms of cash resources to meet its short-term debt obligations.
A working capital ratio between 1.2 to 2.0 is regarded as good, but a ratio greater than 2.0 may indicate that the business is not properly utilizing its assets and liabilities to grow revenues, and also, it is not effectively managing its net working capital.
The collection ratio, also known as the day’s sales outstanding, is an indicator of how well a business handles its accounts receivable. This ratio is computed by multiplying the average number of days in an accounting period by the outstanding accounts receivables average amount divided by the net credit sales’ total amount of net credit sales for that period.
The collection ratio will be lower if a business’s billing department is effective in collections attempts and clients pay their bills on time. The faster a business converts receivables into cash, the lower its collection ratio.
Inventory management is another crucial aspect of working capital management. A company must retain enough inventory on hand to meet customer needs to avoid any surplus inventory that keeps the working assets from making them use at optimal efficiency.
We can divide the goods sold cost by the inventory of the average balance sheet to compute the inventory turnover ratio. It will give you the speed at which the inventory is replaced or utilized.
When you have a low ratio with regards to the competitors, it shows that you have too high inventory levels. On the other hand, a high ratio indicates that you do not have sufficient inventory levels.
Working capital management is not a one-size-fits-all solution. Working asset requirements are influenced by a business’s size, framework, and long-term business plan and several factors:
Do you manufacture something for the service industry? Working capital is influenced by what you do.
Are you a big or small business? Small and medium-sized firms in a variety of industries frequently require more working capital to fund expansion.
Is there a phase when your business is growing and a time when you have limited work? You need a certain cash flow to fulfill the short-term operating costs when you’re busy. You might need it to get past the sluggish months if you aren’t already.
A company’s cash flow and positive working capital are essential to maintain long turnaround times.
If you’ve recently won a big contract and need to ramp up production to meet the deadline, you’ll probably need more working capital.
A rise in price can necessitate the use of working capital to cover the increased cost of goods.
Liquidity and profitability are two primary goals of working capital management. Talking about liquidity, with insufficient working capital, a business will be unable to meet its obligations when they become due, resulting in late payments to employees, suppliers, and other credit providers. Furthermore, it may damage their healthy business relationships with all of them.
Profitability is the second one. Working asset funds typically earn little or no interest. Hence, a business with a high level of working capital may fall short of its investors’ expectations for return on capital employed.
Consequently, there is a trade-off between liquidity and profitability when establishing the optimum level of working assets. Although an optimal level of working capital may exist, it may be impossible to achieve due to variables outside management’s control, such as a shaky supply chain that affects inventory levels.
Working capital management aims to minimize the cost of money spent on working capital and maximize the return on asset investments, furthermore making sure that the company has enough cash flow to cover its expenditures and debt.
A working capital management plan might have a variety of objectives, including:
That being said, it’s equally critical to make good use of your short-term assets, whether it’s by supporting worldwide expansion or engaging in R&D. Your business may not be as successful as it may be if your assets are locked up in inventory or accounts payable. To put it another way, a conservative attitude to the proper management of working assets is ineffective.
Working capital management also involves improving the utilization efficiency of the capital either by boosting the capital returns or lowering the expenses from the capital. Businesses can accomplish the first one by reclaiming cash that is presently stored in order to minimize the necessity for borrowing. In contrast, the second one entails ensuring that the return on surplus capital exceeds the cost of financing it.
Amongst the major working capital management objectives, satisfying short-term obligations tops the chart. Companies can fulfill these by collecting payments from consumers sooner or extending payment terms from suppliers. Obligations may include unexpected costs as well. Thus, they must be an integral part of the working capital management strategy.
Different businesses can use different solutions to support effective working capital management.
1. Companies might gain working capital benefits through electronic invoices. This can lower the chance of errors, automate manual and ordinary operations, and ensure that your clients receive bills as quickly as possible, thus resulting in faster payment.
2. Businesses can plan for any potential financial deficits and take effective advantage of any surpluses by projecting future cash flows. They will be able to make better working capital management decisions as a result of this.
3. Supply chain finance allows buyers to offer suppliers early payment. Suppliers can optimize their DSO by getting paid sooner and at a lower cost of capital. At the same time, buyers can keep their working assets by paying according to agreed-upon payment terms.
4. Buyers can also utilize dynamic discounting to provide early payment to suppliers without the need for an external financier.
5. Flexible funding empowers the buyers to smoothly switch between supply chain finance and dynamic discounting models.
A business can exist even if it isn’t profitable, but it can’t survive if it lacks liquidity. Working capital management serves an equivalent role in a business as the heart does in the human body. It is also a key financial management role.