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Why
Working Capital Management is Important to Make Your Business Successful
What is Working Capital
Working capital is
the difference between current assets and current liabilities. This means the
availability of current assets to operate the business once the current
liabilities are settled.
What
is Working Capital Management
Working capital
management is the process of managing working capital to have a smooth flow of
business operations. Mismanagement of working capital would lead to stuck business
operations and collapse of the business.
Working capital
consists of the following three components.
#
Inventory
Inventory days are
one of the main components of the working capital cycle. The more inventory
holding days or the fewer inventory holding days will decide the level of
inventory holding costs and the liquidity position of the business by
conversion of stocks into cash by the timely settlement of debtor balances.
#Debtor
Balances
Debtor balances also
operate in the same way explained above. The inventory holding costs are
replaced by credit control expenses. However, there is a risk of bad debts and
this should be correctly handled by the credit controller of the business
organization. Proper credit control and timely debtor settlements will protect
the liquidity of the organization by converting debtor invoices into cash.
#
Creditor Balances
Here, the most
important factor is creditor days available. Creditor payments affect the
liquidity position of the company. Therefore, cash retains by the company if
the payments can be delayed up to the creditor days. Even if the company is
having enough cash, creditor payments should not be made before the payments
are due as it may affect the liquidity position of the company. However, there
should be proper management of working capital to make the creditor payments as
they are due, to prove that the business organization is under-controlled by business
ethics.
Why
Working Capital Management is Important
Any business can not
run without proper management of working capital. Therefore, the following
points indicate why it is necessary to manage working capital to have a smooth
flow of business operations.
#1
Reduce inventory days
The business
organization needs to identify the demand plan presented by the Sales Division
of the company. Based on such a demand plan, production should be planned, as the
requirement of production hours and the machine and labor hours required to achieve
the target production. Such a plan prevents over or under-production which
ultimately satisfies the market. While any underproduction dissatisfies
distributors and customers, overproduction will increase stock-holding costs for
the slow-moving stocks adding additional cost to the profit and loss account.
Further, the correct
level of inventory will reduce the market returns as expiry market returns. There
will be an additional cost to collect expired products from each outlet and make
the necessary deductions for the sales invoices of those outlet shops. Further,
the safe disposal of such products may also be a big problem for the company
while being complied with the regulations established on the safe disposal of expired
products. Therefore, it is vital to stick to an accurate demand plan and avoid overproduction.
#2
Reduce debtor days
The business
organization should negotiate with its debtors on the debtor days. The lesser
the debtor days, the higher the liquidity position of the company. And also,
the company should have better debtor relationships and proper negotiations
with its debtors to avoid bad debts and overdue debtor settlements. My blog
post on Financial Ratios (https://globalbizhub.blogspot.com/2023/01/analysis-of-financial-ratios.html)
under my blog, Global Biz Hub describes
all the financial ratios and their formulas coming under working capital.
What is overtrading
Overtrading is another concept that is vital
to be knowledgeable under working capital management. This means that a company
should be on alert that it should not sell further to the same customer until
he settles his first invoice. Even if the debtor looks honest, overtrading is
very risky because that pulls the debtor into a situation of lack of solvency where
he is unable to make the settlements with the available cash as the debt
amounts are very high due to overtraining. Therefore, the debtor is unable to
make the settlements even if he wishes to do so. This will create huge bad
debts for the company. Therefore, companies should not overtrade any customer
whatever the customer relationship the company is having with the customer.
#3 Improves Creditor
Negotiation
The business
organization requires to negotiate with its creditors the maximum number of
days to settle the payments as this would directly impact on the liquidity
position of the company. Here, a great level of creditor relationship is
essential in negotiating the creditor payment periods. The trust between the
debtor and the creditor is essential for a good supplier relationship.
Professional handling of the suppliers will lead to better negotiations and
this will support the liquidity position of the company.
The company should be
careful to make the creditor payments as they are due because suppliers may
charge interest payments for the overdue period which would be an additional
burden for the business.
#4
Improve liquidity position
As described above,
better handling of inventory and better negotiations with debtors and creditors
will lead to proper management of the working capital of the business due to
the improved liquidity position. The cash available within the business can be
used to get cash discounts in purchasing which will be cost-saving for the
business. Further, short-term debts can be settled with the cash available to
avoid additional interest payments due to overdue loans.
#5 Operational
efficiency
The operational
efficiency of the business is improved due to the good liquidity position of
the business. Workers’ and staff salaries can be paid on time, therefore, there
won’t be any distraction for the workers and staff. They will be highly
motivated by the good treatment by their business organization and this would
be reflected in their work performance. Other bill payments such as electricity
and telephone bills can also be settled on time with the cash available and
such essential services will be in operation without any interruption. All these
help to achieve a smooth flow of business operations and efficiency of the
business operations.
Impact
of Working Capital Management on Profitability
As described above,
proper handling of working capital management will avoid the following costs.
- Bad debts
- Unnecessary stock holding costs
- Credit controlling costs
- Interests for overdue debts
- Cost of market expiry returns
Therefore, proper
working capital management is essential to have a profitable business while avoiding
the above costs.
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