The term ‘working capital’ signifies the primary difference between current assets and current liability of a company. Apart from this, the managerial strategies designed by a company to maintain adequate cash flow to meet the short-term operating cost and debts are known as working capital management. The primary purpose of these strategies is to conduct all the operations of the company in a cost-effective way.
The three major components of working capital are –
- Accounts receivable.
- Accounts payable.
Accounts receivable: It is the payment received by the company from customers who have purchased various goods and services on credit. The credit period is generally concise, which ranges for a span of a few days to a few months or in some instances can extend up to a year. Account Receivable is represented as current assets on the balance sheet.
Accounts payable: It denotes the repayment of various goods and services which are purchased by a company on credit within a short period. Account Payable is generally treated as the current liability of a company that needs to be paid within a given period to avoid any adverse situation.
Inventory: The term inventory denotes the raw materials which are used to make goods and finished goods that are ready to be sold. It is regarded as the primary source of income and subsequent earnings for the company’s shareholders. Holding an inventory for long considered a significant disadvantage for the company as it may lead to obsolescence.
Objectives of working capital management
The primary goals include –
Cost of capital:
The cost of capital signifies the weighted average of company debt and the value of equity combined. The interest cost of capital is one of the high prices of any firm. Proper negotiation should be made by the management of the company with its financial institutions to avoid any discord.
Smooth operating cycle:
Smooth operating cycle implies the stable enhancement of a company’s operating cycle without facing any hindrance due to lack of capital, which includes buying of raw materials, tax payments, salaries, etc.
Optimal return on current asset investment:
There are times when an organization may face a lack of capital as well as excess availability of capital. This fluctuation of liquidity always occurs in a business. During times of excessive money, the organization should have the right short term investment avenues which can be utilized for emergency purpose.
Lowest working capital:
It implies that the company has proper managerial strategies and an exact idea about the money required to increase the company’s total value and investing the excess cash to generate investment income or development projects.
The importance of these managerial strategies includes –
- Higher return on capital.
- Higher liquidity.
- Improve credit profile and solvency.
- Increase business value.
- Higher profitability.
- Competitive advantage.
Higher return on capital:
Firms with low working capital will always opt for a higher return on equity. At this moment, the shareholders will get benefited from the higher profit for the money invested in the business.
A large amount of capital is required for the proper functioning of a company so if these capitals are appropriately managed then the company can get benefitted by the additional available money instead of depending on external financing sources. This is important for a small business that can effectively improve its cash management.
Improve credit profile and solvency:
Strategic WCM would help a business to pay its short-term debts, including operating expenses, payment for purchase materials, salaries, etc.
Increase business value:
Firms with systematic WCM would help to generate more liquidity in business, which results in a higher valuation.
The proper management of accounts payable and receivable can play a crucial role in increasing the profitability of a business.
Businesses with a well-planned supply chain will be able to sell more products at a proper discount compared to similar businesses with ineffective sourcing.
Working capital is significant for business as it reflects the efficiency, liquidity and overall progress of a firm. Proficiency can be measured by various methods and ratios. It is vital that you manage your finances and the business properly to avoid facing a working capital deficit and hamper operations.
Experts readily suggest external assistance such as business loans a necessary financial tool to overcome such challenges. Refer to top lenders in case of such situations.