Working capital management refers to a company’s managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities, to ensure the most financially efficient operation of the company. The primary purpose of working capital management is to make sure the company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
Working capital management commonly involves monitoring cash flow, assets, and liabilities through the ratio analysis of key elements of operating expenses, including the working capital ratio, collection ratio, and the inventory turnover ratio. Efficient working capital management helps maintain the smooth operation of the operating cycle (the minimum amount of time required to convert net current assets and liabilities into cash) and can also help to improve the company’s earnings and profitability. Management of working capital includes inventory management and management of accounts receivables and accounts payables. The main objectives of working capital management include maintaining the working capital operating cycle and ensuring its ordered operation, minimizing the cost of capital spent on the working capital, and maximizing the return on current asset investments.
Three fundamental parameters that help you manage working capital requirements better and indicate your liquidity standing of your firm are:
- Working Capital Ratio: A ratio between the current assets and current liabilities, it signifies the current ability of an organization to pay off its short-time financial obligations.
- Collection Period Ratio: Also known as the debtors or accounts receivables turnover ratio, this ratio is indicative of a company’s ability to convert its debts into cash. The lesser number of days it takes to realize its payments from its debtors, the better.
- Inventory Turnover Ratio: Also known as the stock turnover ratio, this ratio monitors the time a company takes to converts its goods into cash. Lower the time taken higher is the company’s stock efficiency.
Nature of Working Capital
(i) It is used for purchase of raw materials, payment of wages and expenses.
(ii) It changes form constantly to keep the wheels of business moving.
(iii) Working capital enhances liquidity, solvency, creditworthiness and reputation of the enterprise.
(iv) It generates the elements of cost namely: Materials, wages and expenses.
(v) It enables the enterprise to avail the cash discount facilities offered by its suppliers.
(vi) It helps improve the morale of business executives and their efficiency reaches at the highest climax.
(vii) It facilitates expansion programmes of the enterprise and helps in maintaining operational efficiency of fixed assets.
Importance of Working Capital
It is said that working capital is the lifeblood of a business. Every business needs funds in order to run its day-to-day activities.
The importance of working capital can be better understood by the following
(i) It helps measure profitability of an enterprise. In its absence, there would be neither production nor profit.
(ii) Without adequate working capital an entity cannot meet its short-term liabilities in time.
(iii) A firm having a healthy working capital position can get loans easily from the market due to its high reputation or goodwill.
(iv) Sufficient working capital helps maintain an uninterrupted flow of production by supplying raw materials and payment of wages.
(v) Sound working capital helps maintain optimum level of investment in current assets.
(vi) It enhances liquidity, solvency, credit worthiness and reputation of enterprise.
(vii) It provides necessary funds to meet unforeseen contingencies and thus helps the enterprise run successfully during periods of crisis.
Classification of Working Capital
(a) Gross Working Capital: Gross working capital refers to the amount of funds invested in various components of current assets. It consists of raw materials, work in progress, debtors, finished goods, etc.
(b) Net Working Capital: The excess of current assets over current liabilities is known as Net working capital. The principal objective here is to learn the composition and magnitude of current assets required to meet current liabilities.
(c) Positive Working Capital: This refers to the surplus of current assets over current liabilities.
(d) Negative Working Capital: Negative working capital refers to the excess of current liabilities over current assets.
(e) Permanent Working Capital: The minimum amount of working capital which even required during the dullest season of the year is known as Permanent working capital.
(f) Temporary or Variable Working Capital: It represents the additional current assets required at different times during the operating year to meet additional inventory, extra cash, etc.
It can be said that Permanent working capital represents minimum amount of the current assets required throughout the year for normal production whereas Temporary working capital is the additional capital required at different time of the year to finance the fluctuations in production due to seasonal change. A firm having constant annual production will also have constant Permanent working capital and only Variable working capital changes due to change in production caused by seasonal changes.