Have you ever found yourself unable to pay your bills or employees? You have spent much time and effort on a substantial project, only to realize you lack the financial resources to see it through.
The Importance of Working Capital
In a broad sense, working capital is money available to cover regular business expenses and one-time initiatives that can make or break a company. Lacking it puts your company at risk of failing and making you personally liable for any debts.
Day-to-day operations require a steady infusion of cash flow provided by working capital. It serves to settle immediate financial obligations and cover ongoing business costs. If you want to boost your business, you must understand this principle.
The Role of Working Capital in Business
Having enough working capital to maintain daily operations is crucial. It is essential to meet fixed costs like rent, utilities, and salaries and buy raw materials.
When a business has positive working capital, it has enough cash to cover its immediate expenses and fund its expansion without tapping into its long-term savings.
If a company has negative working capital, it isn’t making good use of its assets and could face a liquidity crisis. It doesn’t matter how much a company has invested in fixed assets if its liabilities are due before recouping those costs.
And if you don’t have enough cash, how do you keep your business afloat? Bankruptcy!
A reliable history of on-time debt servicing can only benefit a company’s standing in the financial community. Companies can get raw materials on credit with this kind of goodwill. It also has access to bank loans and advances.
Therefore, a company’s creditworthiness is enhanced by its working capital.
Finding Out Your Net Working Capital
The following formula can estimate a company’s net working capital for any accounting period.
Working Capital = Current Assets – Current Liabilities
As a result, your company’s available working capital is determined by two primary variables: the value of your current assets and the number of your current liabilities. Trade receivables, inventory, cash on hand, trade payables, and short-term loans are all examples of existing assets and current liabilities.
Thus, it is critical to deal with concerns regarding the components that make up your company’s assets and liabilities. Here is where the discipline of working capital management comes into play.
What is Working Capital Management?
Managing a company’s current assets and liabilities is commonly known as “working capital management,” which is crucial to its success. Handling issues in accounts payable, inventory, and receivables is part of the working capital management process.
Why Is It Crucial to Manage Working Capital for Your Company?
Insufficient working capital is among the leading causes of business failure worldwide, indicating the importance of working capital management. An organization’s day-to-day cash needs can be reduced by maintaining a healthy level of liquidity.
By practicing good working capital management, you can protect your company’s finances and increase its liquidity. This safeguards against having your company dry up for lack of operating working capital. Any company’s growth, profitability, liquidity, or increased return on capital invested can be bolstered through proper working capital management.
Standard Methods in Managing Working Capital
A team should follow a procedure when managing the company’s working capital. Each company has its unique financial situation and operating capital requirements, so it’s up to them to decide which method is best for them. These strategies typically focus on balancing our current assets and liabilities. When managing their working capital, most businesses choose between three common strategies.
1. Strategy with a Heavy Hand
Aggressive working capital management is practiced by investing as little as possible in short-term assets. Only the amount necessary to pay off immediate debts is kept in “current assets.” This strategy discourages holding onto excess cash and directs its attention toward meeting working capital needs with short-term funding sources.
2. Moderate Method
This working capital management method seeks to balance the extremes of the other two approaches. This “hedging strategy” method involves splitting working capital into temporary and fixed funds. As a result, it’s possible to use long-term funding for things like fixed operating capital needs and short-term financing for things like fluctuating temporary working capital needs. Under this strategy, businesses must balance the opportunity cost of holding idle cash and the benefits of increased liquidity.
3. Strategy Based on Restraint
Unlike the aggressive strategy, the conservative method of managing a company’s working capital encourages more investment in the company’s current assets. As a result, a company adopting this strategy can protect itself from having less cash than it needs by keeping its existing holdings at a surplus. Unfortunately, this strategy carries a high financial cost in the form of wasted money.
Critical Components of Managing Working Capital
When deciding on a course of action for managing working capital, a company should consider the following factors.
1. Money Owed
Short-term commitments in the form of accounts payable are due quickly. Your interest in your accounts payable could go up if you are late. Many companies seek out extended payment terms to better manage their accounts payable.
2. Collections Accounts Receivable
Receivables from customers are the money your company is owed for goods and services provided to those customers. Your company’s ability to pay off its current debts can be gauged by looking at its accounts receivable. In addition to the money you are owed from your debtors, you should also account for any payments that have been promised but have yet to be delivered by adding them to your accounts receivable.
3. Collections Accounts Receivable
Your company’s inventory is a crucial resource that should be managed carefully as part of its working capital. Maintaining a stable stock level is essential for any business. An increase in stock can reduce your company’s liquidity, while a decrease may hinder your ability to meet customer demands promptly.