What is working capital management – why is it important for businesses

CFO Advisory Services

Working capital is one of the most important factors behind a successfully thriving business. It is one of the major indicators of a company’s financial well-being and its easiest source of finance. Financial surveys collectively opine that over 75% of companies that are running at loss or struggling financially would be profitable and liquid if they were more familiar with the concepts of a sound working capital management.

 

What is working capital?

 

Simply put, working capital is the money that is used to finance the day to day operations of a business. It is the financing that is required to pay the current expenses, salaries, materials, and other operating costs of the business.

From a broader perspective, working capital is an indicator of a businesses’ short term financial health. 

Technically:

Working Capital = Current Assets – Current Liabilities

 

Understanding Working Capital Ratio

 

Working Capital Ratio is arrived at by dividing current assets by current liabilities. A ratio ranging between 1.2-2 is considered good.  

Any ratio below 1 indicates a negative working capital. Needless to say that it is considered adverse for the business. However, that does not mean that a higher ratio (above 2) is good either. A higher ratio may be an indication that the business has excess cash/liquid balance available with it and is missing out on re-investing the same.

The challenge for a CFO here is to maintain the right and wholesome balance in the working capital management.

 

Why is Working Capital Management so important for a business?

1. Increased Solvency – Going Concern Status maintained

As we know, working capital is a major source of short term finance. These help to meet short term expenses, salaries,material purchases, etc. Most of these expenses are unavoidable. Hence, good working capital management is a pre-requisite for maintaining solvency and liquidity.

In our 30+years of experience in helping businesses, we have seen that profitability is not the only success metric. We have often come across cases where profitable businesses have gone out of business because they failed to meet their short to medium-term financial needs.

2. Reinvestment – increase in the investment portfolio

In this article, we mentioned earlier that sound working capital management is one where there is no wasted resource/excess cash. Often, the funds of the business get excessively blocked in inventory and debtors (accounts receivables). A good working capital management system ensures that such a scenario does not arise.  It aims at the business being financially solvent as well as created further investment opportunities.

3. Boost to profitability

This goes without saying. Managing short term assets and liabilities can come with costs. Good working capital management aims at increasing profitability by saving some of those costs or by finding out alternative cheaper sources of such financing.

For example: For a business in which the proportion of debtor is high, the in-house cost of maintaining such debtors may be high. Also, bad debts may be high. A large part of these costs may be avoided by engaging a factoring service. A comparison between the cost saved and the factoring cost will be essential in this case.

 

4. Timely availability of resources

Stock management and cash management are some of the aspects of sound working capital management. In some businesses, a proper level of stock management is crucial. Again, in some cases, businesses opting/applying for bank loans may need to maintain certain stock levels for hypothecation purposes.

 

5.Blocks overtrading

 

Overtrading is a situation that arises when a business conducts more operations than what is permitted by its working capital. It may also occur when the business undertakes rash measures to boost its sales without considering its cash planning.

For example: offering huge discounts. Consequently, the company may end up paying for these goods. Or offering excessively long credit periods for large buyers. If a business does these regularly and there are no alternative sources of finance, they may get cash negative and credit intrinsic.

This is probably one of the fastest ways towards financial insolvency. This can be avoided by building and maintaining cash forecast, outlining financial goals and adhering to them.

 

 

6. The window for decision-makers

 

A sound working capital management provides the required data to the business owners and/or decision-makers. It helps them in understanding the underlying requirement of the business and its true financial status. Working capital ratios, budgets, and reports help them in identifying problem areas take corrective action.

 

CFO Advisory Services can be full time, shared, virtual or project-based. Know more about these here: CFO Advisory Services.

 

 

Some common issues faced by small businesses with respect to working capital management:

 

 

  • Meeting increased compliance costs
  • Lack of experienced personnel to create and maintain a sound working capital management
  • Lack of bandwidth in hiring a full-time CFO to handle these
  • Higher levels of debtors
  • Lower availability of credit period from suppliers
  • Increased susceptibility of market changes, dull sales cycle, new compliance shocks
  • Lesser access to loans from banks and financial institutions
  • Lesser access to private equity and other investments
  • Lesser attention of business-owners/decision-makers towards this aspect

 

How to deal with a working capital crunch

 

As they say, prevention is better than cure. Most businesses do not even acknowledge the need of working capital management until they start feeling the pressure. Hence:

1. The very first step is to develop a working capital strategy from day 1

2. Avail a working capital loan

3. Hire a part-time CFO – or project-based CFO to take care of the interim needs

4. Avoid purchasing fixed assets – machines, buildings, office spaces with working capital. Term loans or fixed asset loans are better options for these kinds of investments.

 

We will come back with a detailed piece on how to avoid working capital crunches shortly. Keep watching this space.

 

 

 

 

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For any query, support or feedback, reach us at Taxmantra CFO Advisory Services or Call/WA us at +91-9230033070 for any support/query/feedback.

 

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