What Is Working Capital Management And Why Is It Important?
Working Capital Management refers to the management of the capital that the company requires to finance its daily business operations. The company needs to maximize its operational efficiency, manage its short-term liabilities and assets properly, avoid underutilization of the resources, avoid overtrading, etc.
Its main motive includes the maintenance of 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 to meet the short-term funds required for the operations and pay off the short-term obligations. They need to vary among different industries and similar companies as well. It helps ensure that the company’s operations are performed financially efficiently.
Table of contents
- Working capital management ensures that a company has sufficient liquidity to meet its short-term obligations and maintain financial stability.
- Proper working capital management optimizes the balance between current assets and liabilities, allowing for efficient use of resources. It helps minimize excess inventory, reduce accounts receivable collection periods, and control accounts payable, thereby improving overall operational efficiency.
- Effective working capital management provides the necessary funds for growth and investment opportunities. By efficiently managing working capital, companies can free up cash that can be utilized for expanding operations, acquiring new assets, investing in research and development, or exploring new markets.
Working Capital Management Importance Explained
The importance of effective working capital management is a very crucial aspect in any business, irrespective of the size, sector or industry. An effective management of this working capital helps the business in 9keeping track of its short term liabilities and assets in an efficient manner so that the operations run smoothly without any problem and the company is able to meet its financial obligation at the same time, earn maximum profit.
The importance of working capital in financial management lies in the fact that provides adequate liquid assets for the company to meet its short-term obligations, as and when they are due, like the daily operational expenses, payment to suppliers, or meet any unexpected expense. In this way the company can streamline its cash conversion cycle and free up its resources for faster growth.
Suppose any company doesn’t have enough working capital to cover its obligations. This financial insolvency can lead to legal troubles for the company and even the liquidation of the company’s assets. Thus, the importance of working capital management in new ventures as well as in established companies is a very important aspect of study.
They help not only in covering the financial obligations of the company but at the same time also help 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, all business enterprises need to ensure adequate management of the working capital in their organization. In this way overstocking as well as stockout is prevented, orders are fulfilled on time, reducing bad debts and unnecessary costs.
Thus, the management or working capital is very essential because it ensures that there is a continuous flow of liquidity along with profitability and operational enhancement paving way towards opportunity and growth. In this article we will discuss the importance of working capital management.
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 importance of working capital in financial management lies in the fact that is essential for the proper and smooth working of any business. Working capital management is important in various organizations 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 Company
Suppose the company pays off the debts on time while generating revenues. In that case, it ensures that the company’s operating cycleCompany's Operating CycleThe 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 company’s credit score. Whereas if the company is unable to repay its debts on time and still it is running the business with the low operating costs, the creditors will try to get back their funds, which would lead to a decrease in the credit score.
The pre-requisite to long-term solvency is the ability of the company to meet its short-term obligations. Therefore, the adequate management of the working capital will help the business 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 expensesOperating ExpensesOperating 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..
#2 – Use of Fixed Assets Efficiently
Proper management of the working capital and availability of adequate working capital 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 of unavailability or lack of working capital, the company’s fixed assets remain idle. 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 them. So, the importance of working capital management in new ventures as well as established companies lies in the fact that with the help of working capital management, fixed assets can also be managed and used effectively.
#3 – Ability to Face Crises
If 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. But, generally, the companies don’t have an adequate amount of working capital in case of an emergency, which will negatively affect the business in case an emergency occurs.
#4 – Expansion
If any company plans to expand its business, that would require additional capital. However, if there is adequate working capital management, that could lead to the successful implementation of the expansion program.
Let us try to discuss the importance of working capital management and understand the concept with the help of some suitable examples.
Conclusion: there is a company, ABC Ltd., which pays all its loans, rent, and vendor bills on time; then this would increase the company’s credit score. This shows how responsible management of the working capital can reward the company in the long run. Once the company has a high credit score, it will also qualify for the business loan at a lower rate, making it easier for the company to procure finances easily and lead the business in good financial standing.
A company ABC ltd manufactures and sells pens in the market. In the last month, it purchased the assets to increase 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, the company cannot utilize its fixed assets properly to increase its production due to a lack of working capital. 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, this situation would not have arrived. If there is sufficient working capital, fixed assets can be used properly, and production can increase revenue. This is the perfect example of how working capital management can lead to the effective use of the company’s fixed assets.
There are two companies, ABC Ltd and XYZ Ltd, competing in the town. So suddenly, the situation of depression occurs in the economy. ABC Ltd has an effective mechanism for managing working capital and keeps funds for emergencies. In contrast, XYZ ltd doesn’t properly manage the working capital and doesn’t keep funds for an emergency. So suddenly a situation of depression arises in the economy.
In that case, ABC Ltd will be able to continue its operation as it has proper working capital management, 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 benefits during this time due to a lack of working capital management by its competitor.
ABC Ltd. doesn’t have adequate working capital management and plans 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.
Thus, the above examples clearly show the importance of effective working capital management in any business.
Frequently Asked Questions (FAQs)
Working capital is typically sourced from operational income, short-term borrowings, trade credit, equity investment, efficient asset management, profits retention, and, if necessary, the sale of non-core assets.
Working capital management aims to ensure a delicate balance between liquidity and profitability. Its key objectives are maintaining sufficient liquidity to meet short-term obligations, optimizing the cash conversion cycle for efficient cash flow, effectively managing current assets and liabilities, minimizing financing costs, and providing critical support for ongoing business operations.
Inadequate working capital management can have far-reaching consequences. It may lead to liquidity crises, making it difficult to meet immediate financial obligations. Missed opportunities for growth or investment due to cash constraints can impact profitability. A company’s credit rating may suffer, raising borrowing costs. Poor working capital management can strain supplier relationships, impacting the supply chain.
This has been a guide to what is Working Capital Management Importance. We explain the top reason of it along with some suitable examples. You may also learn more about Accounting from the following articles –