How to manage working capital effectively
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- Category :Finance
Finance is much concerned with the effective utilization of funds. It’s focused on the arrangement of funds at the right time in order that the determined tasks may be carried out satisfactorily. Financial management plays a vital role; on account of which the liquidity position of a business is affected.
The term liquidity refers to the ability of an organization to pay its current liabilities as they come due. Not only does financial management aim at the effective utilization but also at money management. If sufficient funds are available at the time when needed, a company can clear its short term debts; its operations can be maintained effectively and so the working capital financing lends a hand for a business to do well.
Working Capital is defined as, “The administration of the firm’s current assets and financing needed to support current assets.” 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. The concept of working capital should be easily understandable since 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.
“Cash is king” - despite the fact that the cash has its own costs. Cash is the most liquid asset to be presented commonly on the balance sheet as the first item. Management of cash is of great essence for a company. If adequate cash is not available as and when it is needed, the situation leads to bankruptcy. Management of cash and liquidity involves providing sufficient funds to the business for meeting various requirements at the right time, such as, repayment of bank loans, payment of taxes, payment of wages, purchases of raw materials and inventory etc. Moreover, holding the cash entails a precautionary motive in order to meet unforeseen events. Therefore, the cash must be managed properly and provided for arising contingencies. Apart from these, cash management also involves speeding cash inflows and slowing cash outflows. The former case indicates making collections as soon as they come due for collection while the latter indicates the payments to be made as close to the cut-off-date as possible – but it is not be taken in isolation – as it is likely to lose the facility of availing the discounts. So, the payments are to be made close to the cut-off-date while utilizing the discounts if any. In this manner, in the former case, the discount is offered for early payment –to generate the revenue quickly. In the latter case, the discount is availed – to clear the debts and using the facility of discount. This is how the two-fold benefit may be obtained.
Next in importance comes the receivables. It is universal truth that every Business has receivables. They are the dues from the credit customers. There are various reasons for credit sales, such as, to penetrate and establish in the market, to increase sales, to get more customers and to help customers on whom the fortune of a business is contingent. While managing receivables, an organization develops the policies which are beneficial to both customers as well as the organization that makes credit sales. Credit policies must have few standards, credit period, credit terms, etc so as to manage the receivables in an efficient manner. Credit standard is meant to the classification of customers depending upon the relationships and in terms of risk etc. The credit period is referred to how long a period should be allowed. Credit terms mean offering discount on early payment or the payment before the cut-off-date. In the point of fact, it should be understood that making much credit sales leads to great benefits and make profits on the one hand, while it involves the creation of bad debts or risks on the other. Thus, the best possible way is to be adopted for receivable is to manage within the accepted level with the establishment of planning as well as controlling measures.
The impact of inventory management on working capital is vitally important. A company, whether of trading or of manufacturing, has to carry certain amount of inventories. Inventories are classified as inventory of finished goods, of raw materials or of work in process depending upon the type of business. A trading company purchases or sells the finished goods whereas the manufacturing company deals with all types of inventories. At this juncture, it should be noted that having too much or too little inventory becomes a problematic cause in terms of sales and production. Also, even a little less or more amount of increase or decrease in the costs of inventories gives rise to a radical change in terms of overall amount of investments in the inventories. Thus, inventory management involves planning and controlling functions with regard to the order of quantity of even single unit and the specific task of inventory management is to answer the questions: when to order the inventory? How much inventory is needed and if any discounts are likely to be lost by not ordering as per the standard limit of order etc? It is therefore necessary for the process of inventory management to find satisfying answers to the above questions pertaining to various costs of the inventories. It is appropriate to mention that there are several techniques available for the effective management of Inventories with which a management may be benefited.
Mention deserves to be made about the determinants of working capital while the components are being discussed. The same may be outlined herein briefly.
The working capital is influenced by the nature of business. A trading business needs to invest a great deal of money in the working capital as compared to the money required in the fixed assets. The similar case in point is related to a manufacturing business as well.
Business Fluctuations have to do a lot with the management of working capital. The seasonal fluctuations have a great cause in relation to the production and services of a business. It is during a decline in the economy, sales will fall resulting in the level of inventories.
A business firm needs to be prompt in making collections. The working capital is also affected with the credit policy of a business. Establishing a liberal credit policy is having more trade debtors, while a restricted credit policy can reduce the size of trade debtors. However, depending upon the standing of customers and other factors a rationalized credit policy is to be formulated.
To end with, financial management is a distinctive area of business management and the Financial Manager has a key Role in overall business management ensuring the achievement of business objectives and wealth or profit maximization. Financial management is an integral part of overall management affecting the survival, growth and strength of a business. The sole task of financial management is maximization or optimizing the value of a business firm. If dealt effectively and efficiently, a financial manager can ward off a large number of problems while safeguarding the business against insolvency.
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