SOLUTIONS FOR WORKING CAPITAL MANAGEMENT
WHAT IS WORKING CAPITAL?
Working capital is very important for businesses regardless of the size and the sector that the business operates in. It helps in measuring and assessing the long term financial health of the company. Every business must ensure that they utilize their working capital in a very effective way. The current assets and current liabilities are the major components that form the working capital. Working capital is calculated by subtracting Current Liabilities from Current Assets (CA – CL). This tells the business the short-term, liquid assets remaining after short-term liabilities have been paid off Current assets consists of
- Inventory or stock
- Cash or bank
- Account receivables
- Prepaid expenses
- Accrued income
- Other liquid assets
Current liabilities consists of
- Account payable
- Unearned revenue
- Accrued expenses
Whenever the current asset or current liabilities are not managed by the company, it would lead to inevitable consequences. Take for example, if there is a shortage of cash in the company which is a current asset, the company might not be able to achieve any of its short term obligations. If there is a lack of working capital, the business will fail and if there is enough working capital, it will give the push to the business. A business survival is dependent on how adequate their working capital is and the efficiency with which their working capital is utilized.
MERITS OF HAVING A POSITIVE AND ADEQUATE WORKING CAPITAL
The following are the benefits of having a positive working capital:
- Improved liquidity
If you maintain a high level of positive cash flow, there will be enough cash in reserve available for any opportunity and unexpected events. It also allows businesses to have more flexibility in running their business.
- Efficiency in operations
Positive working capital will prevent any future hindrances in business operations. It becomes resourceful in cases where they is delay in the payment of the amount owed by suppliers
- Increased profits
An optimum level of working capital will also lead to more gains for the organization especially when the account payable and receivables
CONSEQUENCES OF HAVING AN INADEQUATE WORKING CAPITAL
Businesses will face the following consequences if they have an inadequate working capital:
- The growth of the business will not be progressive and it will be stunted due to unavailable funds
- It may lead to the non-utilization of the organization’s fixed assets
- The business organization won’t be able to implement its operating plans will in turn lead to the profit goals not being achieved
- The business may lose some credit opportunities due to inadequate working capital
- It may lead to the loss of a good reputation of the firm
- Inadequate working capital won’t allow business organizations to capitalize on new opportunities
- It may lead to loss of trade and cash discounts available to the organization as at that time
- The financial reputation and the goodwill of the business is lost because the organization is not paying its creditors as at when due
- It won’t attract investors and lenders to the business because they won’t want to invest in an organization with inadequate working capital
- A lack of cash or working capital is challenging and difficult especially in the case of any emergencies like recession, strike, labour problem that the organization cannot prevent. An example of this is the Covid-19 pandemic.
- It makes it difficult for the business to grow in the future
- It leads to an adverse working condition in the business organization
WHAT IS WORKING CAPITAL MANAGEMENT?
Working capital management can be defined as the measures implemented in managing the company’s current assets, current liabilities and the relationship between them. A business must ensure that they emphasize on the amount of the net assets or working capital and the measures taken to finance the working capital
Financing will be needed when running the day to day activities of your business organization and as a business owner you need to ensure that a certain working capital level is maintained in order to achieve profitability and liquidity. The goal of working capital management is to manage a business’ current assets and current liabilities in such a way so that a satisfactory level of working capital is maintained.
If you want to have an efficient management of working capital, you will need to consider the following principles
- Principle of risk
A business needs to try to maintain a sufficient amount of current assets in order to meet up with its short term obligations
- Principle of return on equity
Every money that is invested in the business is a risk that should increase the value of the business
- Principle of cost of capital
The cost of capital should also be considered when managing working capital. As the amount of a risky capital increases, the cost of capital decreases, as a business owner, you must try to reduce the cost of capital while managing the working capital
- Principle of payment maturity
The time gap between the payment of debt and the inflow of cash should not be far apart, it should be at minimum. If the gap is high, the risk involved will also be high
OBJECTIVES OF WORKING CAPITAL MANAGEMENT
The following are the objectives of working capital management for business organization:
- To manage the firm’s current assets and liabilities at a balanced or suitable level for the working capital
- To keep a proper balance between the current assets and the current liabilities of an organization
- To decide suitable means or mediums to be adopted for short term financing
- To decide the favourable outcome of level for investing money for gains in the working capital assets
- To decide the most suitable mixture of the short term capital and long term capital
SOLUTIONS FOR WORKING CAPITAL MANAGEMENT
The following are the solutions for efficiently managing your working capital:
- Invoice finance
Invoice financing is for business organizations that make a very high turnover and it ensures that organization releases a higher percentage of the value of unpaid invoices through invoice factoring. You can also outsource this activity to organizations that specialize in it. Invoice finance also allows to you avoid having cash flow problems as it allows you to no longer wait for years or months for your debtors to pay back the amount owed to you
- Debtor protection
Debtor protection deals with providing low cost and easy to manage protection if a customer fail to pay as at when due. Your business will be protected for a higher percentage of a bad debt.
- Assets based lending
Your assets can also be used as a collateral to acquire financing. You can increase your working capital by unlocking the value of a wide array of assets at your disposal such as plants, stock, machinery, equipment, property and debtors. Assets based lending is popular for organizations that are seeking for growth.
Assets based lending could also be used for mergers and acquisition, restructuring and management buyouts. Merits of asset based lending include equity protection, as funds are raised without sacrificing equity, and scalability and flexibility
- Asset financing
Asset financing is another way of purchasing assets that will increase the productivity of your business organization without having an impact of your working capital. There are two ways to finance your asset purchase and they are hire purchase and finance lease
Hire purchase deals with owning the asset at the end of the finance period after paying the lump sum in bits over a particular period.
Finance lease gives you the access to rent an asset without purchasing it. The agreement for a finance lease will include regular rental payments by the borrower an when the asset is sold, you will receive some proceeds
- Managing procurement and inventory
Efficient inventory management is another solution to managing your working capital effectively. When there is an excess stock, it will result to placing a heavy burden on the resources of the business. And in the case where there is insufficient stock, it can result in lost sales and damage to customer relations. This is why you need to balance your stock levels and take the necessary steps in ensuring that there is no holding of unnecessary stocks.
If the stock levels are unknown, it will become difficult to manage the optimum level and the company may experience loss in the long run. You can implement consistent stock checking in order to monitor the level of stock available and ensuring that proper measures are taken in the case of an understock or overstock issues.
- Paying your vendors on time
Ensuring that you cultivate the habit of paying your supplies or vendors as at when due will increase the payables performance of your business. Companies that pay on time develop better relationships with their suppliers and are in a stronger position to negotiate better deals, payment terms and discounts. Keeping your suppliers happy will benefit your organization in the long run.
- Improving your receivables process
Another solution to efficient working capital management is to shorten the receivables period. These are the amounts that business customers and clients are owing. In order to improve your receivables you will need to adopt a good collection system and measures for collecting these payments from your debtors. The best way to ensure you have working capital is to make sure money is coming in on time. Reassessing your contracts and credit terms with debtors may be necessary to make sure you are not giving debtors too big a window to pay for goods and services
- Making informed financing decisions
Working capital is an access to a resource that is interest free with no conditions. You will need to make some financial decisions that is backed up by reliable information. The way to make sure that working capital is managed is to use key performance indicators (KPIs) all the way down the business to operational level. As you map out receivables and payables over time, include inventory metrics and KPIs such as sales outstanding, payables outstanding, and the inventory outstanding. Continuous monitoring of the metrics is crucial to maintaining a sound working capital management strategy.
Application of these various working capital solutions will allow business organizations and companies to make strategic decisions that will lead to increased operational performance and efficiencies. Working capital management is an accurate measurement for assessing the long term financial health of the organization and ensuring that whenever there are short term commitments, there is enough cash flow to meet these needs
Whenever the working capital is not properly managed, companies will suffer various problems that will affect the company’s ability to expand further. This is why it is important for organizations to consistently discuss plans and measures that will ensure that they carefully assess and plan their working capital management
About the author
Onamakinde Dare Daniel is a highly motivated accountant with knowledge in Accounting, Taxation, Management, Audit, Costing and Research. He is keen on tax matters due to its ever dynamic nature.[contact-form-7 404 "Not Found"]