Why is Working Capital Management Important?
Working Capital Management refers to the management of the capital that the company requires for financing its daily business operations and it is important for the company in order to maximize its operational efficiency, manage its short term liabilities and assets properly, avoiding the underutilization of the resources and avoiding the overtrading, etc.
Top Reasons for Working Capital Management
The accounting strategy of the management, which is designed to monitor and utilize the components of the working capital properly, is known as the working capital management. The management of working capital is essential for the proper and smooth working of any business. Working capital management is important in various organization due to the following reasons –
- Improvement in the Credit Profile and Solvency of the CompanySolvency Of The CompanySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.
- Use of Fixed Assets Efficiently
- Ability to Face Crises
Let us discuss these in detail one by one.
#1 – Improvement in the Credit Profile and Solvency of the CompanySolvency Of The CompanySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.
If the company pays off the debts on time while generating revenues, then it ensures that the operating cycle of the companyOperating Cycle Of The CompanyThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company's inventories into cash. is properly funded, which will likely boost the credit score of the company. Whereas if the company is unable to repay its debts on time and still it is running the business with the low operating costs, then the creditors will try to get back their funds, and this would lead to a decrease in the credit score.
The pre-requisite to the long-term solvency is the ability of the company to meet its short-term obligations. The adequate management of the working capital will help the business to pay all of its short-term obligations on a timely basis like the salary payment, payment against the purchase of the raw materials, and other such operating expenses of the company.Operating Expenses Of The Company.Operating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.
There is a company ABC Ltd. which pays all its loans, rent, and vendor bills on time; then this would increase the credit score of the company. This shows that how responsible management of the working capital can reward the company in the long-run. Once the company has a high credit score, then it will also qualify for the business loan at a lower rate, making it easier for the company to procure finances easily in the future and leading the business in good financial standing.
#2 – Use of Fixed Assets Efficiently
Proper management of the working capital and availability of adequate working capital all the time will enable the company to effectively and efficiently use the fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples. present. In case because of the unavailability or paucity of working capital, the fixed assets of the company remains idle then in that case also the depreciation has to be charged, and the interest on capital borrowed is to be paid on fixed assets, i.e., the company has to incur the fixed expenses on the fixed assets unnecessarily even though it is not using it. So, with the help of working capital management, fixed assets can also be managed and used in an effective manner.
There is a company ABC ltd which is manufacturing and selling the pens in the market. In the last month, it purchased the assets for increasing productivity and sales by borrowing the money from the market. The company, however, didn’t look into its working capital position. So even after purchasing the fixed assets, due to a lack of working capital, the company is unable to utilize its fixed assets properly to increase its production. Also, the company has to incur the depreciation chargesDepreciation ChargesDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. and interest on the borrowed capital unnecessarily even though it is not using the fixed assets.
If the company had managed the working capital properly, then this situation would not have arrived. In case there is sufficient working capital, fixed assets can be used properly, and production can be increased, thereby increasing the revenue. This is the perfect example of how the management of working capital can lead to effective use of the fixed assets of the company.
#3 – Ability to Face Crises
In case there is proper management of the working capital, then the business concern will be able to face crises properly during the emergency period like depression. Generally, the companies keep don’t have an adequate amount of working capital in case of an emergency, which will affect the business negatively in can any emergency occurs.
There are two companies ABC Ltd and XYZ Ltd, in a town competing with each other. Suddenly the situation of depression occurs in the economy. ABC Ltd has an effective mechanism for managing working capital and keeps funds for emergencies, whereas the XYZ ltd doesn’t have proper management of the working capital and doesn’t keep funds for an emergency. Suddenly situation of depression arises in the economy.
Now, in that case, ABC Ltd will be able to continue its operation as it has proper management of the working capital whereas XYZ ltd will have to stop the production as it doesn’t have the working capital. Also, ABC ltd with adequate working capital can reap more amounts of benefits during this time due to a lack of working capital management by its competitor.
#4 – Expansion
If any company is planning to expand its business, then that would require additional capital. In case there adequate management of working capital, then that could lead to the implementation of the expansion program successfully.
ABC Ltd. doesn’t have adequate management of working capital and is planning to expand its business. So, in that case, it cannot successfully implement the expansion because it has to arrange the facilities required for the expansion, which currently it is not having because of the inadequate WCM.
Its main motive includes the maintenance of the sufficient cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. in the business every time so that it can meet the short term funds required for the operations and to pay off the short term obligations. They need to vary among different industries and among similar companies as well. It helps in ensuring that the operations of the company are performed in a financially efficient manner. In case any company doesn’t have enough amount of working capital for covering its obligations, then this financial insolvency can lead to the legal troubles of the company and even the liquidation of the company’s assets.
They help not only in covering the financial obligations of the company but at the same time also helps the company in boosting its earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.. Thus, it is very much important for all business enterprises to ensure that there is adequate management of the working capital in their organization.
This has been a guide to Working Capital Management Importance. Here we discuss its meaning along with examples and detailed explanations. You may also learn more about Accounting from the following articles –