Working capital is defined as being the capital of a business which is used in its day-to-day operations. It is the net of current assets minus current liabilities. Working capital ensures whether or not a business organization has sufficient cash flow in order to meet its short term obligations and operating expenses.
The term working capital is used for day-to-day requirement of funds for a business. A business needs certain amount of cash for meeting routine payments, providing unforeseen events or purchasing raw materials for its production. Managing working capital includes managing cash, inventories, accounts receivables and accounts payable in an effective manner. In this way, a working capital is equal to the raw materials, work in progress , finished goods inventories and accounts receivables less accounts payable.
The concept of working capital should be understandable easily, as it is very much connected with our personal lives as well. In the sense, sufficient money is needed for our cost of living. We would like to collect the money owed to us, at the same time, we would like to pay whom we owe.
If the ready money is not maintained properly or we fail to do so, the situation is called as bankruptcy or insolvency. The same applies to a business and the task of financial management in terms of working capital is to maintain sufficient funds for its day-to-day requirements, while safeguarding the business against the possibility of insolvency. Thus, the term working capital refers to the excess of the current assets over the current liabilities.
Current assets of a business are those that will be converted in to cash in twelve months period. They are: Cash, Receivables, inventories, marketable securities and prepayments. Current liabilities are those that are to be settled in twelve months period. Current liabilities are: Accounts payable, unearned revenues and wages payable.
The aim of good working capital management is to maintain balance in having sufficient working capital to ensure that the business is liquid to meet its current requirements. A this stage, it must be noted that being liquid does not mean to be in such a way that it affect or reduce the profitability of the business. Rather, it means to maintain balance by finding ways to smooth out cash payments in order to keep working capital stable. Thus, the importance of managing good working capital emerges due to the fact a business that manages its working capital effectively can survive while meeting its day-to-day operations successfully which in turn leads to the long term success.
It is important for a business to manage good working capital by undertaking each component relating to working capital effectively and efficiently. It must be noted that while the amount of working capital that a company carries can be used to protect it against possible insolvency, it can also affect its profitability as well. So, it is essential for a business management to maintain the balance between liquidity and profitability while managing working capital. Thus, a well-managed working capital is crucial for running a healthy organization.
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