In this article, we cover the working capital management. This includes the definition of working capital management, its objectives as well as working capital management strategies. So, let’s dive in!
Overview
Liquidity is one of the most vital parts of a business. Liquidity refers to how easily a business can convert its assets into cash. Some assets, such as bonds may be highly liquid because they are easily convertible into cash, in a short time. However, some other assets such as fixed assets may take longer to covert, thus, making them less liquid. The main reason why liquidity of assets is crucial is that, for any business, cash is a vital asset. Businesses use cash in operations for several purposes.
Many factors affect the liquidity of a business. Mostly, these factors are internal to a business. Therefore, these factors can be controlled for a better liquidity position. These factors may include uncertainty of cash flows, the ability of a business to raise immediate funds and management policies. There are different methods that businesses can use to manage their liquidity position. Since liquidity is mainly concerned with the cash flows of a business, cash management can play an important role in managing liquidity. Another way that businesses can manage their liquidity is through working capital management.
Table of contents
What is Working Capital Management?
Working capital management is a strategy developed by businesses to manage their working capital. Working capital basically consists of the current assets and current liabilities of a business. Current assets include all assets that can are convertible into cash within 12 months such as accounts receivable, inventories, bonds and cash itself. These may include accounts receivable, inventory, short-term investment, cash and bank balances. Current liabilities are obligations of a business that must be paid within 12 months. These typically include accounts payable or trade payable, accrued expenses or accrued liabilities, and short-term debts, etc.
Working capital management generally involves efficiently managing all aspects of working capital to minimize the risk of insolvency of a business while also maximizing its returns. Generally, this is achievable through managing the cash flows that generate from current assets and outflows as a result of current liabilities. The goal of working capital management is to help businesses meet their short-term operating needs and short-term and long-term debt obligations.
Aside from that, working capital also includes the working capital management financing or working capital investment policies of a business. This includes deciding on which sources of finance to use to finance the working capital requirements of the business. The goal of working capital investment policy is to arrange for working capital to be obtained at the lowest possible cost for the business.
Working Capital Formula
As mentioned above, working capital management mainly involves managing the working capital of a business. Working capital basically consists of current assets and current liabilities. But mathematically, working capital can be represented as the difference between current assets and current liabilities. In other words, working capital is made of current assets minus current liabilities of a business. This can be presented in the following working capital formula:
Working Capital = Current Assets – Current Liabilities
Objectives of Working Capital Management?
Basically, working capital management is primarily concerned with the management and financing of the working capital that a business needs for its operation. However, there are other objectives of working capital management as well.
Strengthen Liquidity Position
First of all, the objective of working capital management is to strengthen the liquidity position of a business. Businesses can achieve this by properly managing their cash flows through useful management of current assets and current liabilities.
Smoothen the Operating Cycle
Another objective of working capital management is to smoothen the operating cycle of a business. The operating cycle of a business starts from when it initially purchases raw materials and ends when it finally sells the product to customers and receives cash for it. So, the objective of working capital management is to ensure that all processes within the cycle are performed efficiently, and there are no stoppages during it.
Shorten the Operating Cycle
Similarly, another objective of working capital is to shorten the operating cycle of a business. This may include targeting the accounts receivable, inventories and accounts payable of a business. For example, a business can decrease its credit term offered to customers, achieve better efficiencies within the production process and negotiate better credit terms with suppliers. All of these will ensure that the operating cycle of the business is shortened.
Lower Cost of Capital
As mentioned above, working capital management may also consist of policies such as working capital investment policies. In regards to this, the objective of working capital management is to lower the rate of interest or cost of capital of a business. By financing working capital with finance that has the lowest cost, a business can also ensure that costs are saved.
Manage Cash Flow for Seasonal Businesses
Finally, another objective of working capital management is specific to seasonal businesses. In these businesses, working capital may reach a surplus at one point in time and reach a deficit at another point. Working capital management can help these businesses manage their cash flows better in times of surplus. Similarly, it can help businesses create a favourable working capital position in the future, thus, helping them in times of deficits.
Working Capital Management Strategies
Businesses develop working capital management strategies that dictate different aspects of working capital. For example, the inventory, accounts receivable, accounts payable management strategies of the business will all be dictated by its working capital management strategy. It may also include making different policies regarding working capital investment or working capital financing.
Working Capital Investment or Financing Policy
The working capital investment or financing policy of business deals with the sources and amounts of finance, for working capital needs, that a business should use or maintain. These may include short-term and long-term sources of finance for current assets and liabilities.
There are different approaches that a business may adopt to achieve its working capital investment policies. These approaches will depend on the variability of the cash inflows and outflows of the business. Similarly, the use of these approaches will depend on the nature and industry of the business. Usually, the business can choose between a conservative, moderate or aggressive approach.
A Conservative Approach
A conservative approach to working capital is for businesses that want to avoid risks associated with working capital management. In a conservative approach, a business will use many long-term sources of finance for its working capital needs. Similarly, in this approach, the business doesn’t only match its current liabilities with its current assets but also keeps some excess amount of current assets for any unexpected situations.
A conservative approach involves the lowest risks for a business. However, it may be considered excessive. This is mainly because some current assets of the business will always stay as reserves and, therefore, not be efficiently utilized. Similarly, the risks are low because long-term finance is used instead of short-term. Therefore, a conservative approach may result in lower profits for the business.
An Aggressive Approach
An aggressive approach to working capital investment policy is the opposite of a conservative approach. The risks involved in this approach are also higher than in a conservative approach. In this approach, a business uses short-term sources of finance to satisfy its working capital needs. This approach assumes maximum efficiency in the working capital management process of a business. It may involve collecting receivables at the earliest possible and paying creditors as late as possible.
An aggressive approach may have the highest risks for businesses but also come with the highest returns. Some businesses may even go with a highly aggressive policy. The risks in this approach are high because the businesses use short-term finance to meet their working capital requirements. Furthermore, the risks are high because businesses depend on timely receipts and payments, which may be very difficult to achieve. Finally, in this approach, no reserves are kept to meet any unexpected situations, which may force businesses into an unfavourable position.
A Moderate Approach
A moderate approach to working capital investment is a combination of both the conservative and aggressive approach. The moderate approach is for businesses that want a middle ground between two extreme approaches. In a moderate approach, the working capital requirements of a business are financed by both short and long-term sources of finance. For permanent current assets, a long-term source of finance is used while for fluctuating current assets, a short-term source is preferred.
With a moderate approach, a business can manage its risks better while also not compromising on the efficiency of working capital. However, this approach needs more attention from management. As the name suggests, the risk level in this approach is moderate as it does not depend on high risk or low-risk finances but uses a combination of both.
Other Factors to Consider for Working Capital Management
There are many other factors that businesses need to consider working capital management as follow:
Size and Nature of Business
First of all, businesses need to consider their size and nature. The size and nature of business dictate its working capital requirements. For large businesses, working capital management is a major part of their operations. On the other hand, working capital management is relatively unimportant for a small business.
Seasonal Nature of Business
Similarly, as discussed above, if a business has a seasonal nature, it may have different working capital requirements as compared to normal businesses. For example, during a busy season, seasonal businesses will require more stock and accumulate more accounts receivable balances. On the other hand, during the off-season, the activity may be relatively lower.
Business Cycle
Likewise, the business cycles of a particular business may also be worth considering for working capital management. This includes periods of boom and bust for the business. These factors may affect different industries or whole economies that businesses operate in. The reason why businesses are affected by the business cycle is that it determines the demand for specific goods. The demand for goods also dictates the working capital requirements of a business.
Credit Limits and Periods
Another factor that businesses need to consider for working capital management is their credit limits and periods, both for receivables and payables. If a business allows higher credit periods and limits, then the business may struggle for cash inflows. Similarly, if the business negotiates low credit periods and high limits with suppliers, it may not be able to pay some of them on time.
Production Cycle
A business also needs to consider its production cycles for working capital management. The production cycle consists of all the processes required to convert raw materials to finished goods. For some businesses, the production cycle may be long while for others it may be short. Therefore, businesses need to consider the effects of their production cycles on their working capital management.
Competition in the Industry
Another factor that businesses may need to consider for working capital management is the competition in their industry. If the industry a business operates in is competitive, then it will need to take quick actions to satisfy customer needs. Therefore, it may require the business to pile up inventories for any orders so it doesn’t miss any opportunities. A higher competition may also require the business to offer better credit terms to customers to attract them.
There are also many other factors that businesses need to consider working capital management. Any factors that affect the working capital, specifically inventories, accounts receivable and accounts payable of a business are worth considering. Some of these factors may also apply to the business as a whole while some others may hit specific areas of working capital.
Conclusion
Working capital management consists of managing the working capital of a business, which can be defined as current assets minus current liabilities of a business. Working capital management can also include the working capital investment or working capital financing policies of a business. The objectives of working capital include managing the liquidity position of a business, smoothening and shortening of its operating cycle, managing the working capital investment policies of the business and helping seasonal businesses with working capital. There are three main approaches to working capital investment policies, which include conservative, aggressive and moderate approaches. Some factors to consider for working capital include nature and size of a business, its business cycle and its credit policies, among other things.
