Working capital management is primarily a business strategy focus on maintaining a healthy balance between your company current assets and liabilities. There are several benefits of efficient working capital management, including the maintenance of sufficient funds in the bank account for day to day operations and to meet all future financial obligations. A Cash flow forecasting model is essential to managing and monitoring your business working capital.
How do you calculate the Working Capital Formula?
Working capital equals current assets minus current liabilities.
Current assets in a company include cash, accounts receivable, inventory and other assets which the business can convert into cash within a year.
Current liabilities include wages, accounts payable, taxes payable and the current portion of a company or business’ long-term debt which are due within 12 months.
The working capital ratio or Current Ratio (current assets divided by current liabilities) is an indicator to show if a company has enough short-term assets to cover its short-term debt. If the ratio of current assets to liabilities ratio is less than one, the company or business is considered to have negative working capital.
The current ratio tells investors and analysts how a company can maximise the current assets on its balance sheet to satisfy its
short-term debt and other payables.
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Advantages of Having Efficient or Adequate Working Capital
Economies of scale – A business with adequate/efficient working capital can reap the benefits of economies of scale by purchasing raw materials or products in bulk or wholesale prices and thus increasing return on working capital.
Improved credit profile and solvency– Adequate working capital management will allow a business to pay on time for its short term obligations – This includes payment for the purchase of raw materials and their operating services. Adequate credit is good for the business’ goodwill and reputation.
Higher profitability– According to research conducted, management of account payables and receivables is an essential driver of business profitability.
Higher liquidity– A company that manages its working capital efficiently will benefit from adequate cash in the bank to fund daily operations with less reliance on external financing.
Favourable financing conditions – Businesses reap the benefits of favourable financing terms such as discount payments from its suppliers and banking partners.
Uninterrupted production – Efficient working capital management allows firms to pay their suppliers on time. The result is the regular flow of raw materials and other resources. Thus production is uninterrupted, and clients receive goods on time.
Ability to handle sudden changes from the norm and peak demand -efficient working capital management helps a business manage sudden changes, including a sudden rise in demand for production in case of an unexpectedly large order.
Competitive advantage – With adequate working capital, a business can afford to discount its products without hurting the company – This gives it a competitive edge and is likely to increase sales and improve turnover.
Easier access to credit facilities – Since a business with efficient working capital has a better financial record than its counterparts; it is easier to access credit facilities when the need arises.
How to finance working capital
Working capital loans are borrowings from financial institutions that companies use to finance their daily operations. There are five most common sources of short-term working capital financing.
Equity – When a business is in its first year of operation and may not yet be profitable, it may require equity funds for short-term working capital needs.
Trade creditors – A trade creditor is a supplier of goods or services that your business owes money. A balance on a creditor’s account means that you haven’t paid the supplier yet. The amount that goes on your business’s balance sheet for trade creditors is the sum of all its unpaid invoices from suppliers currently outstanding.
Factoring – This happens when a business sells its receivable accounts to a third party (a factoring company). The factoring company pays your business at a discount and then collects from your debtors. The difference between the account receivable balance and the discounted amount the factoring company pays you is the profit the factoring company makes.
Line of credit – A line of credit is a limited credit facility extended to businesses by banks or financial institutions. Some requirements may lock out some new or small businesses. However, if your business is well- capitalised, you might easily qualify for one. A line of credit allows businesses to borrow funds for short-term needs when they arise. Usually, a line of credit is meant for one year at a time and are expected to be paid off for 30 to 60 consecutive days.
Short term loan – A good banking relationship with a banker makes it easier for businesses to gain access to short-term loans. A lender may be willing to provide a short- term note for one order or a seasonal inventory and accounts receivable build-up.
In conclusion, we may conclude that a business with adequate working capital has more options and is a more robust business. Thus, working capital management is a crucial part of business management. The business owner or finance controller of an organisation should have methods of financing the business working capital to minimise any disruption in operations, as Proper working capital management can be the difference between a profitable, efficient business and a struggling business.