It has frequently been noticed that a deficit of working capital causes a business to collapse. A commercial company may only succeed if its working capital is managed well.
The business may run its operations while incurring losses, but it cannot thrive without liquidity. It serves a crucial role in financial management as well. Therefore, the management must ensure that the right funding sources are utilized to support working capital and analyze if the company’s short-term commitments are satisfied on time.
This guide will go deeper into the concept and help you understand what are the aspects of Working Capital Management.
What is Working Capital Management?
Working capital management aims to make sure a firm runs smoothly by keeping track of and making the most use of its current assets and liabilities. The management of current assets and current liabilities is also a part of working capital management.
In Accounting terms, Working Capital is the difference between current assets and current liabilities. It can be put as:
Working Capital = Current Assets – Current Liabilities
Objectives of Working Capital Management
Protecting the company’s existence and ensuring it can continue to operate as a viable business involves ensuring it has the necessary resources for daily operations. Lack of cash flow, unregulated commercial credit policies, or restricted access to short-term financing may necessitate corporate reorganization, asset sales, or even company liquidation. That’s why Working Capital Management is used to measure the needs of the corporation in order to sustain the business for the long term.
Components of Working capital
Working capital can be divided into two categories depending on the requirements of the business:
- Based on the time
- Based on the concept
Based on Time
The business always requires working capital. Depending on the timing, the requirement for working capital differs.
It can be further separated into two types:
- Permanent working capital
- Variable working capital
Permanent working capital
Permanent working capital refers to the portion of working capital that is permanently restrained in current assets for the smooth operation of the business. The bare minimum in current assets is needed to run the business successfully throughout the year.
For instance, investments are necessary to keep a minimum supply of raw materials or to keep the cash flow positive. The amount of permanent working capital is based on the company’s size and expansion rate. Further categorization of fixed working capital is possible into the following two groups:
Regular Working Capital
Minimum working capital is needed to maintain the main circulation. For the payment of salaries, commissions, and other amounts, some amount of money is required.
Reserve Margin Working capital
Additional working capital might be needed to cover potential future eventualities. The surplus capital over the requirements of the regular working capital that is set away as a reserve for unforeseen events, such as protests, business slowdown, etc., is known as the reserve working capital.
Factors determining Working Capital
Nature of Business
The size of a firm and the sector it belongs to have a major impact on the makeup of an asset. Compared to huge organizations, small businesses have lower percentages of cash, accounts receivable, and stock. In large organizations, this variation becomes increasingly obvious.
Requirement of creditor
The loan security is of importance to creditors. They desire to have enough money to meet their commitments. They seek a degree of security in assets bigger than liabilities.
Need for cash
One of the current assets that are crucial for the smooth operation of the production cycle is cash. It is always necessary to have a minimum amount of cash in hand to maintain operations. A strong credit relationship also requires having enough cash.
Time
The amount of working capital needed depends on how long it takes to produce a product. The size of working capital increases with a longer period of time. Additionally, inventory turnover and the cost per unit of the sold products affect the amount of working capital.
Production Cycle
The production cycle, also known as the operating cycle, is the length of time needed to transform raw resources into completed goods. The need for working capital increases with the length of the production cycle. So to reduce the amount of working capital needed, the production cycle should be shortened with the utmost care.
The phrase “variable working capital” describes a momentary and varying level of working capital. Variable working capital can shift from one asset to another and fluctuates according to the growth or decline in business activity. Variable working capital can be further divided into the following two types:
Seasonal Variable Working capital
The extra amount needed during the busiest business seasons of the year is known as seasonal working capital. Raw materials like sugarcane, wool, or fibre are required during a specific season.
It is especially appropriate for a seasonal business. To meet the business’s seasonal liquidity, seasonal working capital is needed.
Special variable working capital
Special variable working capital is required to support additional current assets for unforeseen occurrences or unique operations like the execution of special projects or large marketing campaigns.
Based on Concept
Based on the concept, we can divide the working capital into the following categories:
Gross Working Capital
Gross working capital is the sum of all current asset investments. The current assets used in the business provide information about the use of working capital and the enterprise’s financial position. The idea of gross working capital is well-liked and accepted in the financial world.
Net Working Capital
The term “net working capital” is the difference between current assets and liabilities. The company can pay its current liabilities if the net working capital is positive. The net working capital concept provides the benchmark for assessing a company’s creditworthiness.
Conclusion
Working capital does function the same as the heart does for our body. Without effective working capital management, a firm will always run the danger of having a working capital shortage, which will impede its ability to conduct productive business operations and meet its current liabilities.
Major Failures have occurred recently due to working capital shortfalls and poorly controlled cash flows, which have prevented businesses from being able to pay back their debts.
Companies will be able to handle such risks of working capital deficits and maintain a good business cycle if they have the appropriate programs and procedures needed to handle the company’s operations and the appropriate mix of financial products and services from banking institutions to ensure cost-effective liquidity.
Reference
- Working Capital Management – Overview, How It Works, Importance (corporatefinanceinstitute.com)
- What Is Working Capital Management? | Definition & Meaning | Taulia
- Working Capital Management Definition (investopedia.com)
- Working Capital Management: Definition, Calculation, Types & Example | Tally Solutions
- Working capital management definition — AccountingTools
- Working Capital: Meaning, Concept & Nature – Explained! (yourarticlelibrary.com)
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