Importance of Working Capital Management
Sep 25, 2021
What is Working Capital Management?
Working capital management is managing the capital of the entity to finance its day-to-day operational activities. Working capital is the difference between the current assets and the current liabilities of an entity. An asset or liability is considered current when it is payable or receivable within an operating cycle. So, we can understand that the definition of working capital management is how the entity optimises its receivables and payables in the best possible manner to yield the best financial results. There should be a good balance between how many current assets an entity has and the number of current liabilities it owes.
The primary need of working capital management strategy in any business is to pay short-term liabilities on their due dates promptly. Another significant objective of a well-functioning working capital management system is generating profits. A high amount of working capital means an entity needs to earn higher profits to ensure the required return on capital employed. Therefore, it is critical to determine a healthy balance between profitability and liquidity while deciding the appropriate level of working capital management. In the context of working capital management, one needs to be cautious of overtrading and overcapitalising.
Overtrading: Overtrading is a very low or negative working capital. Often, the working capital in such cases is not enough to match the business’s operational needs. Overtrading is extremely dangerous, and in adverse circumstances, it might result in the shutting down of businesses.
Overcapitalising: Having more working capital than what is required results from incorrect working capital management. Furthermore, it reduces profitability.
Importance of Working Capital Management
The significance of working capital management is tremendous, irrespective of the size of the business. Every entity requires a working capital management strategy or plan that is robust and well chalked out, considering various scenarios. Often, we see that profitable businesses are shut down, and it is because they were unable to manage to pay for their liabilities when they were due. Furthermore, a sound working capital management policy even results in higher profitability. Some reasons why management of working capital is essential are listed below.
Higher Return on Capital Employed
The working capital of an entity mustn’t be a lot more than what is required. Higher working capital means a higher portion of assets financed by the owner’s equity. Higher equity implies that higher profits are needed to achieve the required return on capital employed. When the working capital can be efficiently managed and the owner’s equity finances only the required portion of assets, it results in a higher return on capital.
Improvement in Solvency and Credit Profile
When a business pays off its dues on time while generating revenue, it ensures that its operating cycle is efficient. When the business ensures that its operating cycle is efficiently funded, it enhances its credit score. On the other hand, if the entity has low operational expenses but fails to repay its dues on time, it negatively pacts the business’s credit score.
A business with a high amount of working capital has higher liquidity and can pay off its dues even in times of crisis. It prevents businesses from shutting down and facing losses, called shut down costs, and enables surviving the crisis and restoring regular business operating levels.
Efficient Utilization of Fixed Assets
Having adequate working capital and efficient management of the same will help the business’s fixed assets to be utilised efficiently and effectively. Often, the business’s fixed assets remain idle due to the unavailability of components of working capital, such as raw materials, finished goods, and the shortage of funds to buy them. In such cases, even though there is no activity in the entity, it has to pay interests on borrowed funds and charge depreciation on the assets.
Expansion of Business
Any entity that wants to expand its business levels will need to have a healthy level of working capital to finance it. It is required to fund purchase orders and provide credit periods to more customers. Without an adequate and increasing level of working capital, it is challenging for any business to expand its business scale.
Policies such as credit period allowed to customers, cash discounts, and easy monthly installments (EMIs) all bear intrinsic or explicit interest costs. A balanced working capital management policy for all these schemes helps reduce interest costs and thus, results in higher levels of profits for the business.
Uninterrupted Trading and Production
Paying your vendors or creditors on time is one of the essentials of running your business smoothly. If they are not paid on time, they might put the delivery of raw materials on hold. These materials may be required for production or the supply of goods that are traded. It will result in a lower or even a complete halt in production or sales. Such activities harm the business reputation of any entity adversely.
Appreciation in Business Value
An entity that has efficient working capital management has a reputation in the market of being credit-worthy. It enhances the goodwill of the business, and consequently, its market value or share prices. A higher market value means higher wealth created for the business owners.
Edge Over Competitors
A business with an effective working capital management system can sell its products and services at lower prices, as it has lower overall costs.
Better Financing Terms
A business with a reputation for managing its working capital efficiently and paying off its dues on time has a higher credit score and worthiness. Due to this, it can obtain similar facilities from NBFCs, and creditors, such as business line of credit, with more favourable terms, compared to other players in the market.
Ready for Boons and Banes
A business with an excellent working capital management plan accounts for factors such as boons and banes, which are a part of every business cycle fluctuation. They are prepared and well-equipped to handle both deficient and high-demand levels, as they already plan for such contingencies.
How to Manage Working Capital?
Due to the above reasons, we can conclude that an effective working capital management plan brings both strategic and financial advantages due to the reasons listed above. Some of the things one can keep in mind while framing an excellent working capital management plan are mentioned below.
Analyzing Your Experience
Often, the mistakes and losses suffered in the past depict what to look out for and consider while planning for the future.
It means to be alert to changes in the business environment and adapt yourself accordingly. Businesses should be able to anticipate changes in the working capital requirements to seasonal and economic cycle fluctuations, and inflate or shrink the level of working capital, accordingly.
Not Mixing Personal and Business Expenses
Mixing your personal and business records makes it more complicated to determine profits and determine your business’s appropriate working capital levels. When the working capital is not easily identifiable, it results in a lower credit score, lower creditworthiness, and less favourable credit terms. So, you should always maintain separate accounts for your business and personal transactions.
Making Payments on Time
Although this is one of the core essentials of running a business, it is often forgotten and lands even well-established entities in trouble. Paying your trade creditors and other short-term liabilities on time is highly critical to maintain liquidity, market reputation, vendors, and lender relationships, and as a result, keep your business running smoothly.
It is as critical to invoice your debtors and collect payments from them on time as much as it is to pay off your liabilities. On-time collection of invoices ensures that the funds and cash resources of the business are not stretched, and there are enough liquid funds to maintain the business operations smoothly and effectively.
Choosing the Appropriate Source of Funding
There are so many ways to finance your working capital needs. Common sources are a small business loan, loan against POS, vendor financing, debtor factoring, loan against purchase orders, cash credit, and many others. Choose the source that suits your needs the best and is efficient for you. It is effortless to apply for unsecured business loan and get it if your books are in order. Nowadays, a loan for women entrepreneurs in India and a business loan for women can help them boost their business.
So we see that working capital management meaning is nothing but simply how the working capital of a business is managed. The significance of working capital management in a business can never be undermined due to the reasons discussed. Working capital management objectives include keeping the business’s liquidity intact, enhancing operating efficiency, decreasing implicit and explicit interest costs, and increasing the overall profitability of the business.