Every business needs sufficient amount of working capital to run its operations smoothly. Furthermore, it needs to utilize its working capital in the most efficient way possible. This is to ensure maximum return on investment and utilization of fixed assets productively. 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:
- Cash and cash equivalents
- Accounts Receivable
- Marketable Securities
- Prepaid Expenses
- Other Liquid Assets
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 include even going out of business in certain cases. For instance, 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. Hence, lack of working capital may 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 business will depend on:
- adequacy of working capital
- efficiency with which working capital is utilized
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, current liabilities and association between them. It refers to the challenges that a business has to encounter while managing such current assets, current liabilities and their inter relationship. Therefore, a business needs to emphasize on 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 optimum level of working capital in order to achieve the objectives of profitability and liquidity. Therefore, the goal of working capital management is to manage a business’ current assets and current liabilities in such a way so that a satisfactory level of working capital is maintained.
Now, a business needs to consider certain principles while managing working capital. These principles include principles of:
- Return on equity
- Cost of Capital
- Payment Maturity
Thus, a business needs to maintain sufficient amount of current assets so that it is able to meet its short term obligations. Similarly, every penny 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 optimum level of working capital. Finally, the time gap between maturity of debt or payments and the inflow of cash should be minimum. 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 working capital of a business. Let’s understand how each of these components are managed individually to have an optimum level of working capital.
1. Inventory Management
Inventory is one of the important components of 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 the 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 current assets of a business. Hence, a business needs to manage inventories efficiently and effectively.
Management of inventories refer to investing an optimum amount of working capital in inventories. This means that the investment is neither too low nor too high. Low amount of investment in inventories stalls the production process. Whereas excessive investment in inventories lead to blockage of funds. Thus, the investment in inventories should neither 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
- Just in Time
- 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. Furthermore, cash management is an important component of working capital management.
Cash includes coins, currency, drafts, cheques and bank deposits. Furthermore, 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 production. Whereas 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 minimize idle cash
Hence, a business can follow the following strategies in order to manage cash efficiently:
- Business 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 optimum level of cash.
- The business can plan for the utilization 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.
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3. Accounts Receivable Management
Accounts receivable refers to the debtors 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 need to be of an optimum level. It is achieved by comparing benefits with costs in maintaining such receivables.
Thus, excessive investment in accounts receivable increases sales. But leads to high risk of bad debts. Whereas, inadequate amount of investment in accounts receivable reduces sales as well as the risk of bad debts. Hence, a business must compare costs with 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 credit policy clearly to extend credit to customers. This includes setting credit standards, credit terms, offering discounts and analyzing credit risk of customers.
- following a credit collection policy that helps a business to collect payments that become due.
- monitoring the accounts receivable on a constant basis to determine whether the customers are paying according to the credit terms.
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Here is an infographic that explains the working capital management strategies that a small business should adopt in a simple way.