When it comes to the efficient operations of any business, managing the working capital comes into play as one of the critical issues. Practically all businesses, regardless of their capacity and the field of operation, have to rely upon effective working capital management to maintain the business, pay off the creditors and expand. Whether you're a small business owner or running a multi-national corporation, working capital management principles should help you with the skills necessary for enhancing the financial position of your business. Here, we define the term working capital, provide information on its importance, how to calculate working capital and the ways of working capital management.
What is a Working Capital?
The same company considers working capital as total short-term assets minus total short-term liabilities. In other words, working capital is the amount of capital the firm requires in its ordinary course of business to carry out daily operations, as discussed above. The term ‘current’ in this context denotes a particular time frame within which all these benefits and obligations shall be incurred or settled, and this particular time frame gapping cannot exceed one year.
Working capital can also be seen as the net balance between the operational money available for the firm’s ordinary business activities and the amount of money borrowed for such activities. This is further described as including funds meant for spending for more or less immediate purposes, such as purchasing goods, paying employees, settling short-term obligations, and other overhead expenditures. Where such an organization possesses effective working capital management principles, such organization will be able to generate the right amount of liquidity for its short-term liabilities while at the same time controlling the forces that provide for expansion.
That way, it will require a more considerable long-run working capital investment than the amount to be borrowed on a short-term basis to pay for the ongoing operational expenses without worrying about the current liabilities. So, it creates a negative working capital shock, a phenomenon that is viewed negatively concerning the well-being of the firm because management will have to resort to funding sources outside their jurisdiction to pay their creditors.
Importance of Working Capital
Working capital plays an essential role in the lifecycle of any business. It is required to guarantee that the firm runs efficiently regardless of issues with liquidity.
Let’s take a closer look into the importance of working capital:
- Sustaining Optimal Performance: The careful administration of current assets enables the Company to have sufficient cash resources for its day-to-day operations, including acquiring materials, paying personnel, and settling other current liabilities. In this regard, a working capital deficit completely halts any business operations,, invariably resulting in a stoppage of production or services offered.
- Promoting Growth: Working capital management allows the organization to implement certain short-term activities to expand or enter into new market segments. A WCM system allows smooth operations and processes in the organization without having to explore borrowing options, which will put the company at a higher risk of incurring more debts.
- Strengthening Financial Wellbeing: The preservation of working capital within the specified limits reduces the chances of the company experiencing any cash flow problems in the short run while increasing its effectiveness over time. This implies that maintaining certain working capital ratios, is done to protect the corporation against any internal, weak factors like economic recessions or external such as unexpected costs.
- Enhancing Creditworthiness: By improving employers’ and investors’ confidence in the borrower’s ability to repay the loan, they often check the amount of the company's working capital. Proper management of current assets and liabilities will increase the credit rating of your organization, thus allowing you to borrow funds for more significant projects more comfortably.
How to Calculate Working Capital
In most programs, there is generally a module on working capital estimation, a unit in financial computing and financial modeling. Working capital is a hard concept to define in business management, and which the mathematics involved can be expressed as
Working Related Assets = Liquid Assets- Current Liabilities.
But sounding too academic and technical, let us understand working capital in its simplest form as Current Assets Current Liabilities without the symbol.
In this regard, the above parts need to be explained step by step:
- Current Assets: Current Assets indicate cashable values or cash equivalent values held for no more than a year and include cash, Accounts Receivable, inventories and so on.
- Current liabilities: Current liabilities are those that are likely to be settled in less than a year. These include accounts payables, borrowings, accrued expenses and other payables due militated around a year.
E.g.
A company has:₹ 5,00,000 lakh worth of current assets
₹ 3,00,000 lakh worth of current liabilities
Therefore, the difference in the current ratio can be calculated as:500,000-300,000= 200,000
In other words, we can say that the company’s excess working capital can be determined as the company’s working capital, i.e. ₹2,00,000 lakhs, is too far away from being under threat at lease in the near term because the company can meet all the financial commitments including all it’s short-term dents and other obligations that are due within the short frame of time.
Working Capital Ratio
The working capital ratio is a fundamental ratio that is often used in stress tests focused on the timely payment of the company’s debts. It is obtained when the current liabilities are taken to be a denominator and the current assets are elementary determined in the numerator.
A ratio exceeding 1 indicates that the company has more current assets than it has current liabilities which proves to be a good financial position. On the contrary a ratio less than one may signify liquidity issues meaning the company might be struggling to pay its short-term debts.
Working Capital Management Is Inextricably Linked to Some Outside Factors:
In the event that an enterprise pursues liquidity directed management of the working capital components, it is wise to know its determinant factors. They include the following:
- Cash Management: It is very important when scheduling cash inflows and outflows to ensure there is adequate working capital at all times. This means that practically everyday over cash is kept somewhere which is more than what is used in typical business operations and kept idle in low-cost storage. Keeping a cash flow forecast is advantageous in that it helps to avert any cash flow shortages by making it possible to plan in advance for any expected surplus or excess cash.
- Inventory Management: Keeping too much inventory on hand within the organization implies that large sum of money is tied up in cash that could have been invested during other operations within the organization. Once again, if the stock is not sufficient then there is a possibility that sales will be lost. These extremes are successfully taken care of in the use of inventory controls, in which case there are optimal levels of stocks kept, and for other applications of working capital aside from the working inventory itself.
- Accounts Receivable Management: The late payment of customers or long credit period customers have a direct effect on the working capital. One approach is to provide an early repayment discount to customers who settle their payments promptly which improves working capital i.e. cash inflow or decreases the cash collection cycle of credit sales.
- Management of Accounts Payables: Tens of years to clear the suppliers, which would take months, can rather be spent on making working capital pressures. But too much ‘know-how’ relationships binding suppliers cannot be managed for an extended period.
Strategies to Enhance the Working Capital Management
- Track Frequently: Working capital and its ratio should be tracked over time in order to manage any possible threat effectively. It is important for companies to periodically review their liquidity status and take corrective measures whenever necessary.
- Enhance Collection Efficiency: The speed of collecting debts from clients affects the cash flow of any given organization. It is possible to speed up collection by introducing early payment discounts or adopting strict credit policies to customers.
- Tighten Relationships with Suppliers: Taking longer to pay suppliers also means keeping cash for longer, hence enhancing liquidity for businesses.
- Balance Stock Levels: Application of such concepts as JIT management helps avoid keeping too much stock thus tying up funds that could be used for other business activities. Some businesses implement software applications to keep real time stock levels and avoid surplus stocks.
- Invest in Technology: Working capital management tasks can be made easier with the help of financial management systems which enable managing debtors, creditors and stock levels more efficiently.
Conclusion
Businesses needs to understand the concept of working capital and work towards its efficient management. For a business entity, effective management of working capital brings the comfort of not only meeting the short-term obligations of the business but also being able to seize the growth prospects that come into play while remaining liquid for the long term. Businesses practice working capital management by focusing on the elements of current assets and current liabilities, such as cash, receivables, payables, and inventories, to improve their liquidity position and create a thriving finance cycle.
Effective working capital management provides a big chance to businesses to achieve and maintain reasonable levels of liquid assets, which is important for effective functions and expansion of the business in the near future. It is evident that practising the leverages mentioned above to the business owners will help them maintain a favourable working capital position and support the growth of the borderline without straining. To learn more such amazing concepts in finance enrol in our 100% Job-assured Postgraduate Financial Accounting and Management Program.
