Every company needs working capital to manage its day-to-day business. Working capital management definition is the subtraction of current assets from current liabilities. Here is all you need to know about working capital management.
The management of short-term assets and liabilities to manage the day to day operations is called working capital management. The importance of working capital cycle and management cannot be understated as it is the measure of a company’s efficiency to manage its short-term financial health and thus plays a large impact on its profitability.
Since the ordinary course of business demands net investment in different types of current assets, it frequently changes form and is also defined as circular capital. A simple working capital management formula can be described as current assets- current liabilities.
Working capital can take different forms depending on the needs of the business. For instance, it can take the form of cash, then change to inventories and change back to cash. Here are some working capital management examples.
• Gross and networking capital- Gross working capital is the total of current assets, whereas net working capital is the difference between current assets and current liabilities.
• Variable working capital- Working capital needs of a business are subject to constant change. Variables are drawn from short-term financing avenues and are referred to as variable working capital.
• Permanent working capital-All companies need to keep some amount of cash and other marketable securities to run their day-to-day business. This is called permanent working capital and is drawn from long-term sources.
What are the Determinants of Working Capital?
The determinants of working capital are as follows:
• Cash and Cash Equivalents– This is one of the most critical components of working capital and helps in determining a company’s liquid asset balance.
• Inventory– Inventory refers to the stock in hand and is a vital constituent of working capital management. A company needs to consider various costs such as the cost of storage, maintenance and documentation and damage to stored inventory.
• Debtors and Creditors– Debtors refer to the payments that the company is due to receive for goods or services it provides whereas, creditors are the suppliers it needs to pay for the purchase of raw material or other services from vendors. Working capital management refers to the maintenance of balance between the two.
Objectives of Working Capital Management
The main objectives of working capital management are as follows:
• To ensure smooth operation– Efficient working capital management ensures that the operation cycle right from the acquisition of raw material to the delivery of products is carried out without any glitch.
• Controlling the cost of capital– Another major objective of working capital management is to monitor, negotiate and manage the cost of capital to keep it at a minimum.
• Maximizing returns on current asset investments– The aim of every business is to maximize its returns on its invested assets. At any given time, it should be greater than the average cost of capital. Working capital management helps achieve this goal.
How to Determine the Amount of Working Capital Needed?
Every business needs to estimate the working capital needed to function effectively. Wondering how to calculate working capital requirement?
Here are some factors that determine the amount of working capital needed:
• Nature of business– This is one of the primary factors that determine the need for working capital. Manufacturing companies usually require a higher working capital as compared to service-based companies.
• Size of business unit– Working capital needs depend on the volume of the business. The greater the size of the business unit, the higher the working capital need.
• Manufacturing process– Complex production processes require larger working capital as compared to companies with shorter production processes.
• Labor intensity– Small scale industries that are more labor intensive as compared to larger industries with mechanized or automated units require more working capital.
Working capital management strategies
There are mainly three kinds of strategies that companies employ to manage their working capital. They are as follows:
• Conservative approach– In this strategy, the company prefers to have more cash on hand. Thus, both the permanent and variable working capital is financed by long-term sources that result in increased cost of capital. It is a low risk, low profitability kind of approach.
• Aggressive approach– Herein, the company prefers to use short-term funds to a higher degree. Thus, the entire variable working capital, as well as a part of the permanent working capital, is financed by short-term sources. This is a high risk, high profitability model.
• Moderate approach– In this strategy, a company finances permanent working capital needs from long-term sources while relying on short-term methods of financing its variable working capital.
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Efficient working capital management ensures an uninterrupted flow of production on the one hand and solvency of the organization on the other. Besides, it helps a company establish a good credit history in the long run, in turn, helps it to access working capital loans easily.