Working capital management is a series of operations carried out by a firm to ensure that it has adequate resources to meet day-to-day operational expenditures while also retaining resources invested in a profitable manner.
Every company’s working capital is critical to its success, but efficiently managing it is a delicate balancing act. Companies must have adequate cash on hand to meet both anticipated and unanticipated expenses, as well as make the greatest use of existing resources. Accounts payable, accounts receivable, inventory, and cash are all managed efficiently to achieve this.
Importance of Effective Working Capital Management
Protecting the firm’s existence and guaranteeing that it can continue to operate as a going concern requires ensuring that the company has adequate resources for its everyday operations. Cash shortages, unmanaged commercial credit rules, and limited access to short-term financing might force a firm to restructure, sell assets, or even liquidate.
Although the importance of working capital is unquestionable in any type of business. Working capital management is a day to day activity, unlike capital budgeting decisions. Most importantly, inefficiencies at any levels of management have an impact on the working capital and its management. Following are the main points that signify why it is important to take the management of working capital seriously.
- Ensures Higher Return on Capital
- Improvement in Credit Profile & Solvency
- Increased Profitability
- Better Liquidity
- Business Value Appreciation
- Most Suitable Financing Terms
- Interruption Free Production
- Readiness for Shocks and Peak Demand
- Advantage over Competitors
Working Capital Formula
Working capital is calculated by subtracting current liabilities from current assets. That means that the working capital formula can be illustrated as:
Working capital = current assets – current liabilities
Current assets include assets such as cash and accounts receivable, and current liabilities include accounts payable.
Factors Affecting Working Capital Requirements
Every business has different working capital requirements. Working capital requirements can be influenced by both endogenous and external sources.
Endogenous Factors – The size, structure, and strategy of a corporation are all examples of endogenous variables.
Exogenous Factors – Access to the availability of financial services, interest rate levels, industry and products or services provided, macroeconomic conditions, and the size, quantity, and strategy of the company’s rivals are all exogenous variables.
Objectives of Working Capital Management
The primary objectives of working capital management include the following:
1. Smooth Operating Cycle
The key objective of working capital management is to ensure a smooth operating cycle. It means the cycle should never stop for the lack of liquidity whether it is for buying raw material, salaries, tax payments etc.
2. Lowest Working Capital
For achieving the smooth operating cycle, it is also important to keep the requirement of working capital at the lowest. This may be achieved by favorable credit terms with accounts payable and receivables both, faster production cycle, effective inventory management etc.
3. Minimize Rate of Interest or Cost of Capital
It is important to understand that the interest cost of capital is one of the major costs in any firm. The management of the firm should negotiate well with the financial institutions, select the right mode of finance, maintain optimal capital structure etc.
4. Optimal Return on Current Asset Investment
In many businesses, you have a liquidity crunch at one point of time and excess liquidity at another. This happens mostly with seasonal industries. At the time of excess liquidity, the management should have good short-term investment avenues to take benefit of the idle funds.
Factors Determining Working Capital
The working capital requirements of an enterprise depend on a variety of factors. These factors affect different enterprises differently and vary from time to time.
These factors are:
1. Nature of Business
2. Size of Business
3. Manufacturing Cycle
4. Business Cycle
5. Firm’s Credit Policy
6. Operating Efficiency of the Firm
7. Profit Margin and Dividend Policy
8. Expansion and Growth of Business
9. Suppliers’ Credit
10. Loans and Credit Facilities Available
11. Taxation Policy
12. Level of Automation
Advantages of Working Capital Management
- Working capital management ensures sufficient liquidity when required.
- It evades interruptions in operations.
- Profitability maximized.
- Achieves better financial health.
- Develops competitive advantage due to streamlined operations.
Disadvantages of Working Capital Management
- It only considers monetary factors. There are non-monetary factors that it ignores like customer and employee satisfaction, government policy, market trend etc.
- Difficult to accommodate sudden economic changes.
- Too high dependence on data is another downside. A smaller organization may not have such data generation.
- Too many variables to keep in mind say current ratios, quick ratios, collection periods, etc.
Types of Working Capital
In order to finance the working capital in an efficient manner, it is important to understand the difference between the two types of working capital:
1. Permanent Working Capital, and
2. Temporary Working Capital
1. Permanent Working Capital:
This is also called fixed working capital. A part of the investment in current assets is as permanent as the investment in fixed assets. It covers the minimum amount necessary for maintaining the circulation of the current assets in order to carry out the minimum level of business activities. It is that part of working capital that is permanently locked up in the circulation of the current assets. Tandon Committee had referred to this type of working capital as “Core current assets”.
2. Temporary Working Capital:
This is also called variable working capital. A business does not need the same level of current assets throughout the year. For example, during a slack time, a manufacturing firm does not need to invest too much into raw materials, work-in-process, or finished goods inventory because of the decrease in sales.