The Importance Of A Responsible Working Capital Management
Fundamentally, working capital is the difference between a firm’s current assets and current liabilities. A company with sufficient working capital possesses a strong financial standing. Regardless, to ensure the same, businesses are required to adopt effective working capital management strategies and put them into practice.
Ideally, a business should be considerate about the internal as well as the external determinants of working capital while framing such strategies. Read to become familiar with the concept and significance of managing your working capital.
What Is Working Capital Management?
Working capital management is usually described as an accounting strategy that tends to focus on maintaining an adequate balance between a firm’s current assets and current liabilities.
Managing working capital signifies proper handling of cash, inventory, accounts receivables, and accounts payables. Generally, entrepreneurs use key performance ratios like – working capital ratio, turnover ratio, and collection ratio to facilitate efficient management of working capital.
Such financial metrics allow users to identify areas that require more effort to maintain profitability and liquidity.
Components Of Working Capital
Current Assets
Current assets are assets that can be converted into cash within a year.
Examples of current assets include cash, accounts receivable, and inventory.
Current Liabilities
current liabilities are debts that must be paid within a year.
Examples of current assets include cash, accounts receivable, and inventory. Examples of current liabilities include accounts payable, taxes due, and short-term loans.
How to Calculate Working Capital Management?
To calculate working capital management, you need to first calculate the working capital of the company. Working capital is the difference between a company’s current assets and its current liabilities. The formula for calculating working capital is:
Working Capital = Current Assets – Current Liabilities
Current assets include cash, accounts receivable, inventory, and other assets that are expected to be converted into cash within one year.
Current liabilities include accounts payable, short-term loans, and other liabilities that are due within one year.
Once you have calculated the working capital, you can evaluate the effectiveness of the company’s working capital management. There are several ratios that can be used to evaluate working capital management, including the current ratio and the quick ratio.
The current ratio is calculated by dividing the company’s current assets by its current liabilities. A current ratio of 2 or higher is generally considered to be a good indicator of effective working capital management.
The quick ratio, also known as the acid-test ratio, is calculated by dividing the company’s current assets minus inventory by its current liabilities. This ratio provides a more conservative measure of the company’s ability to meet its short-term obligations, as it excludes inventory, which may not be easily converted into cash.
In summary, to calculate working capital management, you need to first calculate the working capital of the company. Once you have calculated working capital, you can evaluate the effectiveness of the company’s working capital management by using ratios such as the current ratio and the quick ratio.
Role Of Responsible Working Capital Management
A business firm can face issues like – bankruptcy, asset liquidation, and legal problems when it fails to cover for its financial obligations. These make it more important for you to manage your firm’s working capital responsibly.
In general, the primary objective of responsible working capital management is to meet financial liabilities smoothly and accelerate your operational revenue.
These pointers elucidate how managing operating capital can help your firm.
Improves Credit Profile And Solvency
By managing your firm’s financial obligations responsibly, you will be able to pay them off on time and help to boost the operating cycle as well. Typically, a firm that can pay off its immediate obligations like the cost of raw materials, wages and salary, etc. manifests robust solvency. It works in favour of the firm owners in more than just one way. For instance, higher solvency can help to secure high-value loans or a large stock of raw materials on credit.
Efficient Use Of Fixed Assets
Often due to lack of working capital, businesses land up in difficult situations, where they are unable to use their existing fixed assets or run their production activities. On top of inactivity, the firm owners have to account for depreciation charges and interest incurred on existing debts. Collectively, it hampers the production process, erodes the efficiency of fixed assets, last but not the least, minimises the scope of generating revenue.
However, one can easily eliminate these challenges by managing their working capital and keeping their operational activities afloat. Entrepreneurs also have the option to inject cash into the production stream by opting for invoice discounting services from a fintech company. Typically, such a move can help businesses raise money on their unpaid invoices and additionally, use the same to meet the working capital gap. In turn, it facilitates the efficient use of fixed assets.
Helps Navigate Financial Crisis
Keeping a tab of the firm’s current assets and current liabilities enables entrepreneurs to devise robust strategies in order to navigate through any financial crisis. Typically, a firm with sufficient working capital can overcome seasonal lows and unwarranted losses. In turn, it necessitates adopting substantial working capital management strategies.
Though businesses have the option to avail a loan to meet their working capital gap, invoice discounting is a much more dynamic alternative. Using a firm’s unpaid account receivables, not only helps to access cash fast but also eliminates the need for increasing one’s debt burden.
Facilitates Expansion
Managing working capital helps businesses to lower their mounting debt while increasing their earnings. As a result, firm owners can consider expanding their scale of operations or production units more seriously.
Notably, businesses also have the option to raise capital by availing of services like – revenue-based financing and lease rental discounting. Firms can seek help from leading fintech companies and avail effective growth capital solutions, by using their future revenue or against the money that is tied-up in rental agreements and leases.
Strategies for Managing Working Capital
There are several strategies that companies can adopt to effectively manage their working capital. Here are some of the key strategies:
1. Improve inventory management
Companies can optimize inventory levels by monitoring inventory turnover rates, reducing lead times, and improving demand forecasting. By doing so, they can reduce the risk of stockouts, minimize carrying costs, and improve cash flow.
2. Optimize Accounts Receivable
Companies can improve accounts receivable by implementing effective credit and collection policies, setting payment terms, and closely monitoring payment cycles. By doing so, they can accelerate cash inflows, reduce bad debt risk, and improve cash flow.
3. Manage Accounts Payable
Companies can negotiate payment terms with suppliers to extend payment cycles and improve cash flow. They can also use automated payment systems to streamline payment processing and reduce administrative costs.
4. Optimize Cash Management
Companies can optimize cash management by implementing cash flow forecasting and management processes, monitoring cash balances, and using cash management tools such as lockboxes and sweep accounts.
5. Use Technology
Companies can use technology such as accounting software, inventory management software, and payment processing systems to automate processes, reduce errors, and improve efficiency.
6. Monitor Financial Performance
Companies can monitor financial performance by regularly reviewing financial statements, cash flow statements, and other key metrics. By doing so, they can identify areas of improvement, adjust strategies, and make informed decisions.
In summary, effective working capital management requires a proactive approach to managing cash flow, inventory, accounts receivable, and accounts payable. By implementing these strategies, companies can optimize their working capital, reduce risk, and improve financial performance.
Bottom Line
The contribution of responsible working capital management is indispensable for the proficient and sustainable profitability of a firm. It can help you in managing your firm’s current assets and liabilities ineffably, and also allow you to run your operational activities smoothly.
