Every business needs a sufficient amount of working capital to run its operations smoothly. Furthermore, it needs to utilise its working capital in the most efficient way possible. This is to ensure maximum return on investment and productive utilisation of fixed assets. This is possible only if various elements of working capital are managed proficiently. Thus, current assets and current liabilities form the major components of working capital as per the working capital equation. Current assets typically include:
Whereas current liabilities include:
- Accounts payable
- Notes payable
- Current portion of long-term debt
- Accrued liabilities
- Unearned revenues.
Hence, mismanagement of any of these components may lead to severe consequences. This may even include going out of business in certain cases. For instance, a shortage of cash may result in incapacity of the firm to meet its short-term obligations. Similarly, inadequate inventories may put production on hold and force the business to purchase raw materials at exaggerated prices. A lack of working capital may also result in business failure. However, adequate working capital gives a push to the business during the days in which there is less business activity.
Hence, to produce goods without any obstruction and sustain sales, a business needs funds for inventories and accounts receivable. Thus, the survival or failure of a business will depend on the adequacy of working capital and the efficiency with which working capital is utilised.
That is to say both inadequate and excessive working capital would undermine the profitability and general working of the business.
What is working capital management?
The term “working capital management” refers to the management of current assets and current liabilities and the association between them. It refers to the challenges that a business has to encounter while managing such current assets and current liabilities and their inter-relationship. Therefore, a business needs to emphasise two perspectives while managing working capital. First is the amount of net current assets or working capital. Second is the method of financing working capital.
Therefore, funds are required in order to run day-to-day operations of the business. And a business needs to maintain an optimum level of working capital in order to achieve the objectives of profitability and liquidity. The goal of working capital management is therefore to manage a business’s current assets and current liabilities in such a way that a satisfactory level of working capital is maintained.
Thus, a business needs to maintain a sufficient amount of current assets so that it is able to meet its short term obligations. Similarly, every cent invested in the form of working capital should enhance the net worth of the business.
Likewise, the cost of capital should be considered while managing working capital. It should be noted that as the amount of risky capital increases, the cost of capital decreases. Hence, a business should make every effort to reduce the cost of capital while maintaining an optimum level of working capital. Finally, the time gap between maturity of debt or payments and the inflow of cash should be minimal. The bigger the gap, the higher is the risk involved.
Strategies to manage working capital
Different elements of working capital, such as bills receivable, cash, inventory, etc., need to be taken care of in order to manage the working capital of a business. Let’s understand how each of these components is managed individually to have an optimum level of working capital.
1. Inventory management
Inventory is one of the important components of the working capital of many businesses. The term inventory includes:
- Finished goods that a business offers for sale.
- Components that form part of finished goods (raw materials, work-in-progress, etc.).
Raw materials are the inputs used to manufacture goods that turn into finished products after some processing. On the other hand, finished goods are products that are ready for sale. Now, the type of inventories and amount of components to be stocked depends upon the nature of business. To conclude, inventories form a crucial part of the current assets of a business. Hence, a business needs to manage inventories efficiently and effectively.
Management of inventories refers to investing an optimum amount of working capital in inventories. This means that the investment is neither too low nor too high. A low amount of investment in inventories stalls the production process, while excessive investment in inventories leads to blockage of funds. Thus, the investment in inventories should neither be inadequate nor excessive. This means a business needs to determine and maintain an optimum level of inventory.
Various techniques are used by a business to determine optimum level of inventory. These include:
- Economic order quantity
- ABC analysis
- Inventory turnover ratio
2. Cash management
Cash is the most liquid of all current assets. All the current assets like receivables and inventory get converted into cash eventually. Hence, cash management is of utmost importance.
Cash includes coins, currency, drafts, cheques and bank deposits. It also includes marketable securities, as these get easily converted into cash. So, cash is an important component of current assets. Therefore, a business should have an adequate amount of current assets at all times. It means that cash should neither be inadequate nor in excess. This is because inadequate cash would hold up production, while excessive cash will remain idle and impact the profitability of the business.
Thus, a business needs to manage cash in order to manage its working capital. Now, the basic objectives behind cash management are:
- To make payments when they become due
- To minimise idle cash
Hence, a business can use the following strategies in order to manage cash efficiently:
- Businesses can prepare cash budgets in order to project cash flows. Cash budgets can help a business to plan and control the use of cash.
- A business needs to determine an optimum level of cash balance by comparing risk with profitability. Various methods are used to determine the optimum level of cash.
- The business can plan for the utilisation of the available cash resources. This can be done after determining the cash flow projections and optimum cash balances. Thus, a business can focus on either increasing cash inflows or reducing cash outflows.
3. Accounts receivable management
Accounts receivable refer to the debts arising on account of selling goods on credit to customers. A business needs to sell goods on credit in order to expand its sales and attract customers. However, there is an element of risk involved in undertaking credit sales. This risk refers to the risk of bad debts. Hence, a business needs to manage its accounts receivable in order to improve its overall return on such receivables. This means investment in accounts receivable needs to be at an optimum level.This is achieved by comparing benefits with costs in maintaining such receivables.
Thus, excessive investment in accounts receivable increases sales. However, it leads to a high risk of bad debts. On the other hand, an inadequate amount of investment in accounts receivable reduces sales as well as the risk of bad debts. Hence, a business must compare the costs with the benefits of maintaining accounts receivable in order to manage receivables effectively. There are certain practices that a business can follow to manage its accounts receivable:
Laying out a clear credit policy for extending credit to customers. This includes setting credit standards and credit terms, offering discounts, and analysing the credit risk of customers.
Following a credit collection policy that helps a business to collect payments that become due.
Monitoring the accounts receivable constantly to determine whether the customers are paying according to the credit terms.
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