Working capital management deals with managerial Decision process regarding determining the level of current asset required, and determining the sources to be utilized to satisfy or meet the required level of the current asset by keeping in view that the impact of this decision on profitability, sale volume and risk level of the business.
What is working capital management.?
In simple word, we can say that it is Decisions relating to working capital and short-term financing are referred to as working capital management.
Working Capital Management (WCM) – Investopedia
The Primary goal of WCM is to maintain the routine operations of the business effectively and efficiently. The major focus of working capital management is on the level of the current assets of the business and its liabilities.
Definition – What does Working Capital Management mean?
You can also determine the performance of WCM on the basis of or with the use of different Ratios like example working capital ratio, inventory ratio, and collection ratio. By using such Ratios you can easily determine the weaknesses and the strengths of your business.
Types of Working Capital
Working capital types can be classified into two aspects.
- Types of Working Capital on the basis of the Balance sheet
- Types of Working Capital on the basis of Operating Cycle
Types of Working Capital w.r. to a Balance Sheet View
on the basis of Balance sheet Working Capital classified into the following two types:
- GROSS WORKING CAPITAL (GWC
- NETWORKING CAPITAL (NWC)
GROSS WORKING CAPITAL (GWC)
In the aspect of a balance sheet, current assets are known as gross working capital. You can describe current asset in the way that these are that short-term asset of an organization that can be converted anytime within one year or within a short interval. sometimes it is very difficult to determine the exact time of the conversion of the current asset because of liability occurs on that asset. In such a case, the need will arise of arranging working capital financing.
NETWORKING CAPITAL (NWC)
You can easily understand NWC in two scenarios. First one is that it is just the difference between a current asset and a current liability of the business on its balance sheet. Another aspect is much deeper in its meaning like you can say that NWC is that part of the current asset that is fixed or permanent portion that is financed from a long-term asset.
Types of Working capital w.r. to Operating Cycle View
Types of Working Capital on the basis of Operation Cycle categorized into following:
- PERMANENT / FIXED WORKING CAPITAL
- TEMPORARY / VARIABLE WC / Fluctuation Portion of Current Asset.
PERMANENT / FIXED WORKING CAPITAL
As its name shows that these are Assets which are fixed and permanent and totally different then Current assets. You also cannot easily convert such type of asset into cash within one year because these asses are financed from long term source of WC financing. We can simplify this classification with the help of given example
Working Capital Management Examples
TEMPORARY / VARIABLE WC
Temporary or Variable Working capital is the fluctuation portion of current assets which is acquired for the sack of meeting the routine activity or the operation of the business. These assets are not fixed therefore it cannot be forecasted.
This can be further bifurcated as below which can create at least some base to forecast.
Seasonal Working Capital: when you tend to meet the seasonal requirement of your business you should for Seasonal WC. For example, the manufacturer of the sweater would increase the production and sale in that season due to higher sales in that period and furthermore as the collection from debtors is also improved in this season.
Special Working Capital: Special working capital as its name shows it occurs only on some special oceans not in routine manner. For example during the Olympic Games or Football games. because during this time business needs of working capital in order to meet the sudden demand.
It was all about the types of working capital now it depends on the manager of the business that what kind of sources he can utilize to increase the productivity of the organization.
Importance of Working Capital Management
Before going to explain Importance of Working Capital Management we make it clear that Working Capital is the part of the whole capital invested by the company and sometimes defined as the difference between short-term liabilities and short-term assets. In simple word working capital is the current asset which can be converted within one year or less than one year into cash in order to run the business smoothly and increase turnover rate.
WC is the most significant part of the business that can be helpful in various field like as under:
HIGHER RETURN ON CAPITAL
Organization provide high Return on capital with low working capital which results the shareholders take much interest because they got a higher return on there for every single dollar they invested in the business.
IMPROVED CREDIT PROFILE AND SOLVENCY
Because of Working Capital Management organization are able to meet the short term obligation on time. this obligation may be in the form of salaries, include raw materials, and other operating expenses.
According to the latest research conducted by Tauringana and Adjapong Africa, if you properly manage all of your account payables and account receivables it means you are achieving higher profitability. Because the management of account payables and receivables is an important factor or driver of small business productivity and profitability.
Higher liquidity refers that how much your business is able to convert the asset into cash. A large amount of money can be stuck in the working capital. In case of small business if you manage your working capital efficiently then you are able to run your business smoothly.
Because small businesses often settled their bills in cash which comes from earning. With the help of proper working capital management, one business can allocate the resources in a very smart manner.
INCREASED BUSINESS VALUE
Smart working capital management lead towards generating more cash flows which result the increased in the value of Business.
Favourable FINANCING CONDITIONS
If you have a good relation with you stack holder like partner, supplier and make their payment properly on time then it is the gesture of Favorable financing condition of your firm. Because in this way there is a chance that you can get the discount payment or Loans from the supplier or from lending institutions like Banks.
When you make payment to the supplier then they will provide you with the raw material without any delay. This will make cause to UNINTERRUPTED PRODUCTION.
ABILITY TO FACE SHOCKS AND PEAK DEMAND
The proper working capital management will help the business firm in their tough time and save from the crises of the sudden increase in demand.
The proper working capital management gives the competitive edge the Firms over other businesses. If your firm equipped with an efficient supply chain this will let to sell their products at discount rates.
Working Capital Management Strategies
There is always risk involved in business. This is the common thing that when there is no risk there is no profit. Therefore companies must measure its risk involve in business and then make positive strategies to handle the risk by ensuring the positive cash flow.
This step is called Working Capital management strategies. The major goal of making such strategies is to create a balance in between current asset and current liabilities in order to meet the daily operations and short term obligation of a business organization.
When we come to the Working Capital Management Strategies we will find the main strategies are sometimes also known as approaches. These strategies are used to choose the mixture of long term and short term source of financing for the business firm which is as under:
- Conservative approach in working capital management
- An aggressive approach in working capital management
- Hedging approach in working capital management
Working Capital Management Strategies-Approaches Graph
For equations, following abbreviations are used:
FA = Fixed Assets
PWC = Permanent Working Capital
TWC = Temporary Working Capital
Hedging Approach in Working Capital Management
A heading is that approaches to working capital management in which you convert your asset into cash slowly as needed. According to this approach, the manager tends to go to acquire the sources of financing either from current assets or from fixed assets.
Now it depends upon the circumstances that if you want to go for long-term financing you will have to go for Permanent Portion of your Asset which is normally known as Fixed Asset.
And on the other hand, if you want to go to meet the short-term need then you should go for short-term financing for the liquidation of your short-term assets. Here, funds are applied as below and you can see it in the above diagram.
Long-Term Funds will Finance >> FA + PWC
Short-Term Funds will Finance >> TWC
Conservative Approach to Working capital Management
This is the conservative approach to working capital management in which the manager are conservative to his decision.
In this approaches all the sources of financing including Fixed Portion of assets and current or temporary assets are acquired from long-term liabilities + Equities with low risk and low profitability.
Long-Term Funds will Finance >> FA + PWC + Part of TWC
Short-Term Funds will Finance >> Remaining Part of TWC
Aggressive Approach to Working Capital Management
In this approaches to WCM, the manager is more aggressive toward his decision about the source of financing. Because the major focus in this strategy is on higher profitability. It is the common thing that as much as you go to the profit you risk is also increasing with the same percentage. This is a high-risk high profitability strategy.
Here the manager goes to finance the long-term sources are utilized to acquired the fixes assets and on the other hand, all the temporary WC and part of the fixed asset are also financed through short-term sources. Here, funds are applied as below this can be seen in the above mention diagram.
Long-Term Funds will Finance >> FA + Part of PWC
Short-Term Funds will Finance >> Remaining Part of PWC + TWC
Working capital management formula
How to Calculate Working Capital
Working capital is calculated by using the current ratio, which is current assets divided by current liabilities. A ratio above 1 means current assets exceed liabilities, and the higher the ratio, the better.
How can you describe the Components of a working capital?
In simple word Working Capital Management (WCM) the process in which the manager take the decision about the effective and efficient use of the components of current assets and current liabilities in order to maximize profit and minimize the loss.
There are Two major components of a working capital management (WCM) are current assets and current liabilities. Each one describes below:
Components of a working capital
Current assets which are also known as the fluctuation part of the asset that can be converted into cash easily and very fast. Like example cash on hand, short-term investments, inventory and accounts receivable etc.
Account Receivable is the very essential part of assets which should be collected as soon as possible. Because as soon you received your Debt you will be in the position to invest them back. Effective management of inventory is also essential of every organization.
You should have enough quantity of inventory to meet the requirements. It should not exceed from your requirement because in this case, your additional cost will be high like storage cost etc.
Current Liability is the trend that every company incurs some liabilities in order to meet its routine operations. For example, if you want to purchase the inventory for your business or you have to pay the salary of your staff, or paying off taxes you can incur the liability.
Unearned revenue will also be considered your liability because you have been paid for the product but delivery not yet made. For the good gesture of an organization, it is necessary that the current liability should be paid during one financial period of time.
If you are interested in Financial Ratios then check: