Let’s say you want to buy a mobile phone, but you don’t have cash in hand. You need to wait until month-end when the salary gets credited to your account. You lose patience and ask for money from your friend. He helps you on the condition to return the money within a month. You are able to buy your phone, and also able to return your friend’s money by month-end. This way you bridged the financing gap. This is exactly what working capital management means, bridging the gap and managing the short-term financial needs of a company.
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What is Working Capital?
Working Capital is the bridge between long-term financial needs and short-term financial needs. Long-term finance involves the cash flow over an extended (long) period of time i.e. 5 to 15 years, while short-term finance involves cash flow within a year (short) or within the operating cycle. Working capital management is short-term financial management.
What is Working Capital Management?
Working capital management is concerned with the problems that arise in an attempt to manage the current assets, the current liabilities & the interrelationship that exists between them. The current assets refer to those assets which can be easily converted into cash in the ordinary course of business, without disrupting the operations of the firm. Striking a balance between the current assets and current liabilities is an art. The balance should be such that it proves beneficial to the company. Working capital management is all about increasing the ability of the firm to function smoothly and meet its daily obligations without concerns.
Is it really necessary for the company’s success?
Yes, it is the critical for smooth functioning of companies. The capital which needs to be used for working or functioning of a company needs to be adequately funded. Maintaining working capital at an optimum level is necessary as too much or too little is extremely harmful. If it is too little the company will not be able to meet its minimum obligations on time, and thus would suffer from a cash crunch. If it is too much then the company may be losing on the opportunity cost of reinvesting the excess amount and earning out of it. There comes the working capital management concept to help maintain an optimum level of capital.
Components of Working Capital
Key Currents assets under consideration-
- Accounts Receivables
- Marketable Securities
Key Current Liabilities under consideration-
- Bank Overdraft
- Outstanding Expenses
- Accounts Payable
- Bills Payable
The objective of Capital Management is to manage the firm’s current assets & liabilities, in a way that ensures operational efficiencies.
If the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent & may be forced into bankruptcy. Working Capital planning would mean maintaining the margin of safety by ensuring that the current asset should be large enough to cover its current liabilities.
Thus, working capital management acts as a bridge between the current assets & current liabilities.
Concept of working capital:
There are 2 concepts:
- Gross Working Capital
- Net Working Capital
Gross working capital
It is referred to as total current assets. Focuses on, Optimum investment in current assets: Excessive investments adversely impact a firm’s profitability, as idle investment earns nothing. Inadequate working capital can threaten the solvency of the firm because of its inability to meet its current obligations. Therefore, there should be adequate investment in current assets.
GROSS WORKING CAPITAL = TOTAL CURRENT ASSETS
Financing of current assets: Whenever the need for working capital funds arises, arrangements should be made quickly. If surplus funds are available, they should be invested in short-term securities.
Net Working Capital
- Difference between current assets and current liabilities.
- Net working capital is that portion of current assets which is financed with long-term funds. Below is how you calculate Net working Capital or Working Capital formula
NET WORKING CAPITAL = CURRENT ASSETS – CURRENT LIABILITIES
WORKING CAPITAL RATIO = TOTAL CURRENT ASSETS/TOTAL CURRENT LIABILITIES
The Working Capital ratio is also termed the Current Ratio. 2:1 is an ideal ratio which means that current assets are adequate to cover current liabilities. If the working capital is efficiently managed, then liquidity and profitability will improve. They are not only the components of working capital but the outcome of working capital. Working capital is basically related to the question of profitability versus liquidity & related aspects of risk.
In 2020, Due to Corona Virus, Retail industries reduced their working capital by billions, as “Lockdown” impacted sales adversely.
What do you do to ensure working capital management?