Definition of Working Capital Management:
Working capital is a measure of firm’s efficiency and its current financial health. Managing the operational capital is called as working capital management. Every firm has short term assets and short term liabilities, they are also known as current assets and liabilities. It is calculated by subtracting short term liabilities from short term assets. The working capital ratio determines if the firm is financially stable, and has enough short term assets to cover its short term debts.
If the ratio is less than 1, it implies that working capital is negative. And if the ratio is more than 2 then the company is not investing in excess assets. Experts are of the view that ratio ranging 1.2 – 2.0 is sufficient.
Working capital is one type reflection of company’s efficiency. Amongst every other thing an investor analyzes, working capital is surely one of them. Money owed by customers or money utilized in inventory is almost negligible because that can’t be used to pay for company’s obligations. If this is the case and problem of slow collection arises, then the company might face some problem in its operations.
To understand what working capital management is we need to know the case scenarios where it is needed. Let’s say a company’s short term assets are less than its short term liabilities, which means that it doesn’t have enough assets to cover its debts. This may lead to bankruptcy.
A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. Working captial example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.
Efficiently maintaining a balanced ratio between current assets and current liabilities is called working capital management. Working capital management ensures that that the company has enough monetary liquidity to meet short term debts. Structuring an effective working capital management is a great way to enhance the income. Ratio analysis and management of individual components of working capital are two primary importance of working capital management.
Process of determining and analyzing numerical relationships in accordance to financial statements like balance sheets, income statements and cash inflow statements is known as ratio analysis. The primary purpose of ratio analysis is to appraise the operating and financial performance of an economic activity and determine its efficiency, profitability, liquidity and solvency. It also helps in getting a brief idea about comparative valuation by comparing ratios of different companies in the same sector.
Inventory management involves overseeing the purchase of new items and managing the existing ones. It aims to create such a purchase plan that will ensure effective delivery of materials. Two most used inventory management strategies are ‘the just-in-time method’ and ‘material required planning.’ In former one the firm plans to receive items at the time of need rather than maintaining high inventory levels, and the latter one is based sales forecasts.
Cash management is process of collecting, managing and utilizing the cash inflow to optimize the short term financial stability. The key component in accomplishing this task is solvency. Successful cash management is useful when any unexpected demand for cash occurs out of the blue.
Objectives of Working Capital Management:
Few of the importance objectives of working capital management are listed below:
1. Optimization of working capital operating cycle – In simple terms, working capital cycle starts from the day raw materials are acquired and completes when the finished products are sold. The major objective of working capital management is to ensure that there is no hindrance during the above mentioned process. It includes collecting and processing raw materials and other initial investment in time, placing all the essentials for production beforehand, selling finished products as soon as possible, collecting account receivables on time and clearing all the account payable’s in time.
2. Balance Working Capital – The net working capital mentioned above is required to stay in a stable equilibrium. The ratio of current assets and current liabilities should be optimized. Because the lower value of this ratio implies that company is not financially stable to clear its current debts, higher value is also not an indication of prosperity, it suggests that company has too many inventories and they are not investing in excess cash.
3. Minimize cost of capital – Working capital management focuses on minimizing cost of capital, rate of interest per say in some special cases. It is only when the cost of capital will be lesser than revenue, one can earn profit. Utilization of long-term funds (in proper mix) is one way of minimizing capital cost. The fundamental principle of financial management should be followed sincerely while deciding the finance mix, always. The principle states that long term sources should finance fixed assets and permanent assets. Also, the short-term or temporary assets should be financed by short-term sources of finance.
4. Optimal Return on Current Asset Investment – The return on the investment infused on short term assets must exceed the average cost of capital to ensure wealth maximization. In other words, the rate of return earned from the investment in short term assets should exceed the rate of interest or cost of capital. Working capital management aims to extract maximum from an investment in current assets to ensure higher profitability.
So by now you know that working capital management is a managerial accounting strategy that aims to optimize higher ROI (return on investment) and minimize cost of capital. During any financial crisis, the accounting team focuses on enhancing the company’s working capital management to normalize day to day business activity.
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