What is Working Capital?
Working capital is a measure of both a company’s efficiency and its short-term financial health. It is calculated as current assets minus current liabilities. E.g. If total current assets of the entity are Rs.15 lakhs and total current liabilities are Rs.9 lakhs then Rs.6 lakhs is required to run business and day to day activity smoothly as working capital.
As per various studies, one of the major reasons for the poor performance of business entities in our countries has been a lot of funds locked up in working capital. It is one of the best gauges of company’s liquidity position as well as the cheapest source of finance. Generally following three elements of the business are very important in performance.
Corporate entities have to look into releasing cash blocked in operations for their working capital which will improve the returns from their business and reduce working capital requirement and for that, they have to focus on inventory management, accounts receivables, account payables process etc. i.e. its operating cycle.
How working capital analysis boost liquidity and profitability?
- By reducing debt.
- By reducing the cost of capital.
With the right expertise and good experience, analytics can draw the following action to reduce operating cycle:
- Identify the cash balance which allow for the business to meet day to day expenses.
- Reduce cash holding cost.
Raw material, wages and overhead:
- Payment to supplier on time will create good relationship and improve credit period.
- Make order in bulk as per requirement to get discount.
- An organization can reduce working capital by eliminating waste, improving co-ordination etc.
- Identify the level of inventory for uninterrupted production.
- Lead time in production should be lower to reduce Work In Progress.
- Finished goods should kept at low or optimum level to avoid cost of holding like cost of storage, spoiled, damage etc.
- Send correct invoice on timely basis.
- Identify appropriate credit policy.
- Gives discount and allowance to make prompt payment to avoid bad debt.
- Conduct rigorous credit check on new customers.
- Create effective payment process.
- Employ efficient collection team.
Importance of working capital management:
- Firms with lower working capital will post a higher return on capital so shareholders will get the benefit.
- Working capital helps to run the business smoothly without any financial problem for making the payment of short-term liabilities.
- Sufficient working capital enables a business concern to make timely payments and hence helps in creating and maintaining goodwill.
- A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and good terms.
- Quick payment of credit purchase of raw materials ensures the regular supply of raw materials from suppliers.
- Adequate working capital enables a firm to face a business crisis in emergencies such as depression.
- To avoid liquidation of assets and potential bankruptcy.
- It allows business to not only cover their financial obligations, but helps a corporate entity to boost their earning.
- Firms with an efficient supply chain will often be able to sell their products at a discount versus similar firms with inefficient sourcing.