On top of that, you need funds to bid on an order or a long-term project that will help your company thrive in today’s competitive business environment. How do you manage all of this on your own? The solution lies in working capital management.
In this blog, we will talk about what working capital management is and how it works, you can manage your operational costs effectively.
Working capital is a metric that shows how much excess cash your company has to meet its short-term obligations and fund its day-to-day operations. You can compute this figure by deducting current liabilities from your current assets.
Before we proceed, let’s talk about current assets and liabilities first.
Current assets are the resources you can easily convert into cash within one year. They include accounts receivables and inventories.
Current liabilities are the debts you have to pay within one year. They include account payables and accrued expenses.
Now that you know working capital, let’s understand the meaning of working capital management.
A working capital management project is a company strategy aiming to optimize the use of an enterprise’s current assets and liabilities. Its primary goal is to ensure the business has ample cash flow to meet its short-term commitments and invest in long-term growth.
Some key components you need to consider when comprehending working capital in financial management are:
Cash is your company’s most liquid asset. However, holding too much cash sometimes means you are not utilizing it properly, not capitalizing on investment opportunities, and not putting funds towards acquiring productive assets.
Hence, the suggestion is to forecast your monetary needs, monitor current cash inflows, and manage outflows.
Receivable refers to invoices that you have yet to receive from your customer. Always, weigh your credit policy. Remember, you may not develop your consumer base if you are too severe in providing your services or goods on credit. If the credit period is long, you may have difficulty recovering from clients, causing a disruption in cash flow.
Payables are the invoices your company owes to your suppliers for the goods or services purchased on credit. When it comes to unpaid invoices, you must negotiate favorable terms with your suppliers, pay bills on time, and take advantage of discounts or incentives.
Inventory is the stock of goods the company holds for sale or production. Your company must balance the trade-off between holding too much or too little inventory. If you stock excessive inventories in advance, you might block significant funds that could be used elsewhere.
Working capital ratios are financial ratios that measure a company’s ability to repay both short-term and long-term obligations. To ensure effective working capital management in finance, you must learn about these metrices.
Current ratio This metric assesses a company’s capacity to settle short-tenure debts using existing assets. This ratio indicates a company’s short-term financial viability. The formula is: Current ratio = (Current Assets ÷ Current Liabilities)
Quick ratio It evaluates a company’s capacity to settle immediate debts using quick assets, which are current assets that you may readily convert into cash. The formula is: Quick Ratio = {( Current Assets – Inventories) ÷ Current Liabilities}
Cash ratio This ratio gauges your firm’s capacity to clear short-term obligations with cash and cash equivalents. The formula is: Cash Ratio = (Cash and Cash Equivalents ÷ Current Liabilities)
Operating cash flow ratio This ratio measures the number of times a company can pay off current liabilities with the cash generated in a given period. The formula is: Operating Cash Flow Ratio = (Operating Cash Flow ÷ Current Liabilities)
Working capital turnover ratio This ratio gauges how efficiently your business utilizes its working capital to generate sales. The formula is: Working Capital Turnover Ratio = (Net Annual Sales ÷ Average Working Capital)
Average Working Capital = {(Current Assets – Current Liabilities) ÷ 2}
Some common parameters affecting working capital requirements are:
Different enterprises have varying capital requirements. For example, if you own a Kirana store, your working capital requirements will be low because you will have a short operating cycle and may be selling things for cash only.
On the other hand, a business owner who runs a manufacturing plant with each product costing lakhs has little possibility of making a cash sale. In such a case, they may require extra working capital to keep their manufacturing cycle running smoothly.
Every company has a time of year when the demand for its product peaks. Consider the example of gold ornaments. During Dhanteras and Diwali, Indian families visit jewelry stores to make significant purchases. In such instances, jewelry dealers’ working capital requirements increase drastically to ensure they do not fall short of meeting their projected demands and have adequate funds on hand to manufacture jewels promptly based on the order they receive.
If you manage a business relying heavily on manual labor, ensure you never run out of working capital. You need money to pay your employees’ salaries, group medical insurance premiums, and remuneration to freelancers or consultants affiliated with your company.
However, a corporation with fully implemented technology does not need to retain large financial reserves. That is because businesses will require significantly less funds to improve or maintain technologies rather than paying large salaries.
Despite being outside a business’s control, certain external factors can still impact your working capital needs. These factors include the level of interest rates, inflation, taxation, exchange rates, government policies, market conditions, etc. Depending on the situation, these factors can positively or negatively affect a business’s working capital.
Working capital management is a vital part of financial management. It has a direct impact on the liquidity, profitability, and solvency of a business. As an entrepreneur, improving working capital can improve your cash flow, reduce financing costs, increase earnings, and enhance competitive advantage.
If you neglect working capital management, you may face cash shortages, lose customers and suppliers, incur losses, and jeopardize your firm’s survival.
