If a company is unable to meet its short-term responsibilities, it cannot produce a profit over the long term.
Because of this, they have a special reserve called working capital that is set aside specifically for use in running the business. Effective short-term financial decision-making is what working capital management is concerned with.
Working capital management aims to make sure that there is enough money on hand to cover ongoing costs while also making sure that assets are not sitting about in an ideal situation and are instead invested in worthwhile ventures.
Because of this, the business must balance its current assets and liabilities as best it can to accomplish successful working capital management.
Concept of Working Capital
Working Capital is the cash, which is required to run the day-to-day operations. The funds are used for activities like:
- Buying raw materials and turning them into finished goods.
- Paying wages and salary
- Making short-term financial investments
- To handle expenses incurred during the one-year production cycle, etc.
Working Capital = Current Assets – Current Liabilities
Working capital is also used as a way to analyze the liquidity of a business. If current assets are more than current liabilities, it is a good sign that the business can cover its operating expenses and other short-term financial obligations.
But at the same time, excess current assets should not be left ideal, they should be invested in profitable places.
This is why it is important to maintain a productive balance between the current assets and current liabilities. And this balance is proof of effective Working Capital Management.
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Factors that determine the Working Capital
There is no set fund benchmark when it comes to working capital. Many factors together determine the working capital requirements of a business. And the factors are as follows:
- Organizational Structure
- Company size and growth rate at which cash is infused in grabbing industry opportunities
- Investing and borrowing activities of the company
- Company’s effective and stringent credit policy when it comes to collecting money from debtors
- The operational efficiency in managing the cash conversion cycle
- Banking services and their current loaning facility
- Interest rates allotted by the Reserve Bank of India
- The economic growth and inflationary trends in the share market
- Barriers to entry and exit for regulated competition in the industry
- Development of new and costly innovations and technologies
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Why an effective Working Capital Management is important?
The reasons for adopting effective working management are:
Ability to handle crisis
With the help of effective working capital management, the company can face unprecedented situations with more ease that is, they will have a strong hold on the cash in hand.
And if the company is faced with any challenge, they can effectively use the available fund to steer clear from it.
Two companies, A and B, operate in the same industry. Company A has effective working capital management, whereas company B does not. Suddenly, the economy faces depression.
This unprecedented crisis will be handled differently by both companies. On one hand company, A with the help of effective working capital planning can maintain production, whereas company B fails to meet the crisis and stops production.
Here, company A can earn more benefits, as its competitors lose the market base.
Improving credit profile of the business & maintaining solvency
The best way to improve a credit profile is by paying off the debts timely and if the debt is paid off, solvency is maintained and this will enable the firm to have easy access to bank loans.
The better the credit score, the higher the chances of getting aid from financial institutions and banks in times of need.
A company, say, XYZ Ltd., can use its current assets properly in paying off the debt. In the long run, its credit score will go up which will allow it to take business loans at cheaper rates.
Ready for expansion opportunities
Proper working capital management means effective utilization of funds. So, during the expansion projects, adequate working capital will help with the easy implementation of expansion plans.
There will be no hindrances due to a lack of funds and the expansion plan can be executed smoothly.
PQR Ltd. does not follow effective Working Capital Management. This means when expansion opportunities arise, due to scarcity of funds, it will not be able to arrange the required facilities for expansion and miss out on the opportunity.
Utilizing fixed assets efficiently
When there is a scarcity of working capital, it may affect the fixed assets as they will not be used but will continue to lose their value.
This means that without proper working capital to run the day-to-day operations, the machinery will not be able to run at its full capacity and the company will have to continue paying the repair and depreciation expenses from reserved funds.
Say a bread manufacturing company recently borrowed funds and bought a new machine (fixed asset) to increase production. But it turns out that the company does not have sufficient working capital to complete the production cycle.
So now, because of ineffective working capital management, the company will have to pay loan interest, and depreciation charges and also suffer losses due to less production.
Working Capital Management must be equally as effective as financial management if a company wishes to have excellent financial health. Long-term financial decisions are directly impacted by the efficient management of the short-term activity.
Furthermore, analysts considering investing in a firm are well aware of the importance of this characteristic as a deciding element.
For them, the business must have enough cash on hand to at the very least be able to manage their day-to-day operations and maintain their relevance in the market.
As a result, any company that falls short of this requirement will soon file for solvency, which is something you as an analyst will want to avoid.
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