Introduction
Every modern technological innovation opens up immense entrepreneurial opportunities- digital payments, blockchain, e-commerce, AR/VR or AI. However, your ideas and capabilities to follow through an entrepreneurial journey will also decide career success and growth.
But do you know why the majority of business initiatives fail? The answer is unstable 'cash flow'. Even the most innovative idea can fail to sustain a business if you compromise on Working Capital Management.
Effective financial management is crucial for business success and sustainability.
This article discusses the importance of managing working capital and how to keep businesses financially stable.
Understanding Working Capital Management
Working capital suggests a company's liquid resources or cash for meeting daily and short-term operational expenses. These expenses include purchasing inventory, paying raw material suppliers, wages and salaries.
However, any payment obligation and receivables due after 12 months cannot be a part of the working capital calculation. How well a company manages its working capital is one of the key indicators of its financial health.
In accounting terms:
Working capital = current assets - current liabilities
In this context, it is vital to understand the concepts of current assets and current liabilities.
- Current assets = convertible in cash within a year
- Current liabilities = payable to creditors within a year
4 Components of Working Capital Management
The four essential components of managing working capital efficiently and effectively are,
- Cash management involves the efficient collection, disbursem*nt, and utilisation of cash, including cash flow forecasting and optimising cash conversion cycles. It helps maintain adequate liquidity and make informed financial decisions.
- Inventory management focuses on forecasting demand, monitoring stock levels, implementing just-in-time inventory systems, and minimising carrying costs. They ensure having the right amount of stock without tying up excessive capital.
- Accounts receivable management handles outstanding customer payments. It includes credit assessment, setting credit limits, invoicing, and monitoring collections. Receivables management decreases the risk of bad debts and improves cash flow, among other things.
- Accounts payable management optimises a company's payments to suppliers and vendors. It involves negotiating favourable payment terms, taking advantage of early payment discounts, and managing cash outflows.
Types of Working Capital
Regarding the periodicity of receivables and payment obligations, there are six categories of working capital. Here is the list:
- Permanent working capital - rent, payment to utilities, wages, salaries and loan EMIs
- Regular working capital - a part of permanent working capital necessary for daily expenses
- Reserve margin working capital - a fund set aside outside the regular working capital (but as a part of permanent working capital) to cover unforeseen events
- Gross working capital - total fund invested in current assets like inventory, cash, payment receivables and liquid investments
- Net working capital - the gap between current assets and current liabilities
- Variable working capital - the fluctuation in required working capital due to seasonal and unpredictable variations in business
Importance of Working Capital Management
Here are some of the main reasons why Working Capital Management is crucial for business success:
Cash flow: neither too low nor too much
Efficient Working Capital Management ensures enough liquidity to cover daily expenses and short-term obligations. It helps companies to avoid cash shortages, minimise the dependencies on costly external financing, and reduce the risk of financial distress.
Manage inventory without creating dead weight
Working Capital Management helps maintain an optimum level of stock for businesses involved in manufacturing or retail. By carefully monitoring and controlling inventory levels, companies can avoid overstocking, reduce carrying costs, improve turnover ratios, and free up cash for other business needs.
Stronger and steadier supplier relationships
Healthy supplier relationships are critical for smooth business operations. Managing working capital efficiently and effectively allows companies to build trust with suppliers and negotiate better terms. It may include extended payment periods, priority services in competitive markets or higher discounts for cash payments.
Avoid expensive debt traps
A right Working Capital Management strategy reduces a company's short-term debt obligations. With sufficient working capital, you can timely repay loans, avoid penalties and interest expenses and enjoy and enhance your credit rating.
Working Capital Management Ratios
Ratios offer critical insights into the health of working capital for any company and help to develop suitable management plans. A few of the critical working capital ratios include:
- Current ratio - the proportion of current assets to current liabilities. A higher current ratio indicates better liquidity and financial stability.
- Quick ratio - a strict measure of liquidity, similar to an acid test. It is calculated by dividing quick assets (current assets minus inventory) by current liabilities.
- Days sales outstanding (DSO) - computed by dividing accounts receivable by average daily sales. A lower DSO indicates quicker payment collections and better cash flow management.
- Inventory turnover ratio - computed by dividing the cost of goods sold by the average inventory. A higher inventory turnover ratio indicates better inventory management and faster inventory turnover.
Conclusion
Finally, a practical understanding of Working Capital Management is essential for leadership and management responsibilities. Finance and accounts may not be your forte. But the capability to maintain financial discipline is critical to managing any business vertical.
Besides, maintaining a healthy cash flow will be necessary if you want to pursue entrepreneurship. Adopt strategies to maintain a healthy flow of income and expenses. It improves your risk appetite.
Check some relevant courses on leadership and strategies to grasp the concept better.
