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Working Capital Management – Small Business Owners

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Working Capital Management

What is working capital management?

Working capital management is when a business plan is maneuvered in such a manner so as to ensure that a company can operate efficiently by using and monitoring its existing assets and liabilities in the best possible way, it is known as working capital management.

Working capital management – objectives

In order to ensure the liquidity of finance, there are two main objectives of working capital management. The first one is managing timely payments from customers as insufficient cash flow (working capital) will lead to the company’s failure in fulfilling obligations as they fall due, which again might result in late salary distribution to employees, late payment to suppliers and other credit providers. This, in turn, may result in losing the loyalty of employees, losing supplier discounts and hence a falling credit rating. Furthermore, default on the part of a company may give rise to consequences such as the compulsory liquidation of assets in order to repay creditors.

The second key objective is generating profits. Funds used as working capital are more likely to earn very little, or in fact, no, return. Therefore a company with a high level of working capital might not achieve the expected return on capital employed, i.e., {Operating profit ÷ (Total equity and long-term liabilities)} as expected by its investors.  

Hence while determining the working capital’s appropriate level there is a trade-off between profitability and liquidity:

  • Overtrading – not enough working capital to match the level of business activities. This can also be called under-capitalization and is categorically characterized by a high rising ratio of short-term finance to long-term finance
  • Over-capitalisation – an excess level of working capital, thereby resulting in inefficiency.

Working capital management – its importance

Working capital means the existing net current assets required for daily operating activities. It can also be defined as the total of current assets minus the current liabilities wherein its components are generally trade and inventory receivables along with bank overdraft and trade payables.

Many big businesses that, at first sight, may appear profitable often are forced to shut down due to their inability to handle short-term obligations at times when they fall due. Hence successful management or maneuvering of working capital is a necessity for a business to remain in existence.

Working capital management needs great care owing to potential interactions among its components. For instance, if the credit period that is offered to customers is extended it can result in extra sales. However, in such cases, the company might have to rely on a bank overdraft as its cash position may fall owing to the extended wait for payment from customers. Sometimes the overdraft’s interest might surpass the profit gained from the additional sales, particularly if there is a rise in the cases of bad debts.

The importance of managing effective working capital

Although the role of working capital is vital in any form of business, managing the working capital is a daily activity, unlike capital budgeting decisions. Furthermore, inefficiency at any stage of management may have a negative impact on the working capital and its management. Given below are some important points that show why it is vital to take the management of working capital seriously.

  • Makes possible Higher Return on Capital
  • Improvement in Solvency and Credit Profile
  • Better Liquidity
  • Increased Profitability
  • Uninterrupted Production
  • Business Value Appreciation
  • Edge over Competitors
  • Most Suitable Financing Terms
  • Being Ready for Peak Demand and Shocks

Working capital relevance

The ratio of working capital is very crucial to creditors because it shows the company’s liquidity. The current liabilities are paid with existing assets like cash, marketable securities and cash equivalents. The faster the conversion of an asset into liquid cash, the higher are the chances of the company successfully paying off its debts. When the current liabilities are higher than the current assets, there will be ample capital for the company for its daily operations.

In other words, the company will have sufficient capital to work with. Hence this ratio serves as a measuring scale of a company’s short-term financial health and efficiency. Anything below 1 indicates a negative W/C (working capital) whereas anything over 2 is indicative that the company is not investing the surplus assets. The ratio between 1.2 and 2.0 is regarded as the most ideal ratio. The second name for working capital is net working capital.

How is working capital calculated?

Working capital is found out by reducing the current liabilities from the current assets which imply that the working is calculated by the following formula:

Working capital = Current assets – current liabilities

The current assets are the current liabilities and accounts and cash receivable including the accounts payable.

Some important things are as mentioned below:-

  • DSO or Days Sales Outstanding – the no. of the days in average required by the customers of the company for paying the necessary invoices.
  • DPO or Days Payables Outstanding – the no. of the days in average required by the company which it takes for paying the suppliers.
  • DIO or Days Inventory Outstanding – the no. of the days in average required by any business required for selling its inventory or stock.
  • CCC or Cash Conversion Cycle – the no. of the days in average required by any business for converting the investment of the inventory in cash.

The formula for calculation of CCC is as mentioned below:-

CCC = DIO + DSO – DPO

The smaller a company’s CCC is, the faster it converts the cash into the inventory and again back to the cash. Companies may greatly reduce the cash conversion cycle or CCC in 3 ways:

  • Asking their customers for faster payments (DSO)
  • Increasing their payment tenure to their suppliers (DPO)
  • Decreasing the time for which their inventory is being held (DIO)

Formulas for working capital analysis

There are many different formulas for analysis of working capital analysis, some of them are mentioned below:-

Ratio Analysis – Used for measuring the short tenure of any firm’s liquidity

Ratio of Liquidity

Formula

Ratio

Assets Current/ Liabilities Current

Ratio of current

Assets Liquid/ Liabilities Current

Quick Ratio also known as Acid Test Ratio

[ Short-term securities which also includes Cash and Bank] / Liabilities Current

Ratio of cash position/ Liquid Ratio Absolute

The ratio of Inventory Turnover = Total cost of all the goods sold/average cost of the inventory

When one does not know the cost of the goods of the items sold check the below formulas:-

Formula

Ratio

Goods Sold Cost/Cost of Average Inventory

Ratio of Inventory Turnover

Net Sales/Average Cost of Inventory

Total Cost of the Goods which are Sold / Inventory at the Selling Price in Average

Working capital in simple words

Working capital, in simpler terms, is a difference between a business’s current liabilities and its current assets.

Current assets such as inventories, receivable accounts, and cash.

Current liabilities are short-term borrowings, liabilities accrued and accounts payable. A common approach is to subtract this cash from the current assets and from current liabilities one needs to deduct the financial debt.

Types of working capital

Working Capital is basically divided into 2 main categories as mentioned below:-

A. Based on the capital generated, the working capital is:-

  1. Networking capital – the difference between current liabilities and current assets
  2. Gross working capital – a company’s current assets

B. Depending on the time period, the working capital is:-

  1. Variable working capital – extra capital left after fixed working capital

Fixed working capital – investments required for starting and managing any business.

Gross working capital’s importance

The investments in these current assets should not be inadequate or excessive than required since it can impact negatively on the capacity of production and also lead to the solvency of this company. This greatly undermines any business’s profit. Gross working capital helps in maintaining this that is why it is crucial.

Net Working capital’s importance

The networking capital is important for checking the liquidity position and for ensuring that these current assets are exceeding the current liabilities. This capital number also provides its creditor a very clear picture of the financial soundness of the company.

Measuring the efficiency of the working capital

The efficiency of the working capital can be easily measured by various ratios. The cycle of working capital and its corresponding ratios are generally compared to the benchmarks of other industries and peers of the company. Some of the general measures which are generally used while estimating the working capital management efficiency often include the current ratios, inventory outstanding days, payables outstanding days, sales outstanding days, etc. For the small-scale operations in the small business, the money flow is always in a tight supply and the investment in this area of the working capital might be an issue.

Some of the small companies are mostly unable to fund these operating cycles with payable accounts and so, need to depend on this cash which is mostly generated by various internal income sources such as the owner, etc. if one is able to manage the working capital efficiently, these small businesses would be easily able to free up their cash for paying debts or for the reinvestments.

Effective capital management

Working capital management is the core factor to the effective management of running a business because:

  • current assets include the majority of the  assets in case of some companies
  • shareholder wealth being more closely related to the generation of cash rather than accounting profits
  • Inability to control the working capital, and hence to control liquidity, is a major reason for the corporate collapse.

Finding the working capital estimate of the company

  1. The profits must be ignored while calculating its working capital as its profits can or cannot be taken again as the working capital and even though this amount could be greatly reduced due to dividends, taxes and others.
  2. One should consider 100 percent WIP value unless otherwise mentioned.
  3. Stock calculation of the completed products and all the debts should be done at the cost unless otherwise mentioned.

Factors that affect the needs of working capital

The needs of the working capital are not the same for every company. It varies from business to business. There are two factors that affect working capital needs. They are

  • Endogenous – Endogenous factors are the ones that can include the size of the company, its structure, and its strategy.
  • Exogenous. – Exogenous factors are the one’s which includes
    • the availability and access of banking services
    • interest rates
    • services or products sold
    • type of industry
    • macroeconomic conditions
    • the number, strategy and the size of competitors of the given company

Liquidity management

For managing liquidity properly one must ensure that a particular business possesses proper cash resources for the daily business needs and also the required fluidity for some unexpected needs of any amount which is reasonable. This is very important as it affects any business’s creditworthiness, which would be contributing to determining any business’s failure or success.

The lower any business’s liquidity the more likely any company would face financial distress while the different conditions are equal.

But, too much of the cash which is parked in or low- or non-earning assets will also reflect some poor resource allocation.

For liquidity management to be proper, it should be manifested at some proper level of the cash or/and the ability of any organization to efficiently and quickly generating the cash resources for financing the business needs.

Accounts receivables management

The company must grant the customers flexibility or commercial credit level while ensuring the proper amount of cash inflow.

The company would be determining these credit terms for offerings dependent on the financial capacity of any customer, the policies of the industry, and the policy of the competitors.

Any credit term needs to be ordinary that implies that the customer generally must be given a number of days for paying their invoice. Any business’s policy and manager’s discretion needs to be determined if different conditions are required, like cash on delivery, cash before delivery, periodic billing or bill to bill.

Read More – Accounts receivable financing

Inventory management

The inventory management ensures that any business stays on a proper level of the inventory for dealing with fluctuations for the demand and with the day-to-day operations without too much investing into any asset.

An excessive inventory implies that there is an extra amount of the capital which is tied to the company. This increases any risk of the unsold inventory and also the potential obsolescence which erodes inventory value.

A shortage of inventory must be avoided, as this would imply the lost sales of the company.

Short term debt management

Just like any liquidity management, the short-term financing management must be focused on ensuring that any company has enough funds required in financing the short-term operations without any excessive risk.

The management of the short-term finances requires the selection of a proper financing instrument and also sizing any funds that are accessed through each of the instruments. Some of the popular sources are uncommitted lines, regular credit lines, collateralized loans, revolving credit agreements, factoring and discounted receivables.

The company must ensure there would be proper access in liquidity for dealing with the cash needs at peak. Such as, the company requires a revolving credit agreement for dealing with any unexpected funds.

Accounts payable management

The accounts payable start from any trade credit which is granted by any suppliers of the company, for normal operations. There is a proper balance between commercial debt and early payments.

The early payments might reduce any liquidity available in the company that can be used in more productive ways.

Late payments can destroy the reputation of the company and its commercial relationships if it is at a high level of debt might reduce the company’s creditworthiness.

Solutions for the working capital management

Companies can deploy a wide range of solutions to ensure effective working capital management, both for their suppliers as well as for themselves. These include:

  • Electronic invoicing – Submitting electronic invoices results in fast delivery of invoices to customers thereby fetching fast payments. This method enables companies to transform purchase orders into invoices automatically.
  • Cash flow forecasting – By forecasting the future cash flows the companies can prepare beforehand for any upcoming cash gaps and ensure better use of any surpluses.
  • Supply chain finance – Also called reverse factoring – it is a way of offering suppliers early payment via one or more third-party funders. Suppliers then improve their DSO by getting paid early at a low cost of funding.
  • Dynamic discounting – This is another solution that buyers can use to make early payments to suppliers and allow buyers to secure an attractive risk-free return on their surplus cash.
  • Flexible funding – Last but not least, working capital providers that offer flexible funding might allow buyers to choose between supply chain finance and dynamic discounting models. In other words, companies can adapt to their different working capital needs while continuing to support their suppliers.

Working Capital Management FAQs:

1. State the components of the working capital

The elements of the working capital are money going out, money coming in and inventory management.

2. What is the aim of working capital management?

The aim of working capital management is for maximising the operational frequency of the company.

3. How can you minimize CCC?

You can minimize CCC by reducing DIO and DSO and increasing DPO.

4. Is a higher working capital good for the company?

Yes, higher the working capital more efficiently the company will function.

5. State the formula for finding working capital ratio

Formula for working capital ratio is the ratio of the total assets to the current liabilities.

6. What is the operating cycle?

Operating cycle is equal to the inventory period plus the accounts which are acquired in that period.

7. What is the range of the good working capital ratio?

The ratio between 1.2 and 2.0 is considered as a good working capital ratio.

8. State the formula for inventory days

It is the no. of days in that given period/inventory ratio (turnover)

9. What is a bad working capital ratio?

A working capital ratio above 2 is considered a bad working capital ratio.

10. What does a working capital ratio above 2 indicate?

A working capital ratio above 2 indicates lost business opportunities and poor financial management.



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