December 1, 2020

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Working capital management: Meaning and key Explanations

Working capital management: Meaning and key Explanations
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While working capital is the difference between current assets and current liabilities, the management of it is an important part of every financial manager. But what is it?

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Definition of working capital management

It can be defined as the planning, organising and controlling of an entity’s working capital.

It can also be seen as the control of firm liquidity and current assets so that it has optimal working capital.

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Key Explanations

It deals with planning, organising and controlling of working capital. The planning of working capital means having the cash available to meet the entity’s obligations as they are ready for financing.

After an adequate plan has been made, the entity’s management needs to organise its current assets and current liabilities. Then a control mechanism will be set up to ensure that the company met its working capital needs.

Working capital management aims to ensure the right amount of working capital. Excessive investments in current assets will enable the company to meet its current obligations. Such as operating costs financing, account payables and current long-term debts repayment.

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However, such actions will make the company unprofitable. That’s such money should have been reinvested to earn more income for the entity.

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Having insufficient current assets, on the other hand, may lead to liquidity issues. This, although, may have generated more income and profit to the entity. Therefore, the right mix of working capital is required. These will cover both liquidity and profitability.

Managing Working Capital

Working capital can be managed as follows

Having the right cash forecast: Forecasting the entity’s future cash flow can help in managing and monitoring working capital. These can be done by knowing the figure of cash daily, weekly basis and monthly. Then the firm will know the periods in which it has more cash. When it needs more cash to meet operating costs, pay accounts payables and loan obligations.

Analysis of the firm’s working capital using ratios: There are majorly two ratios that can be used to monitor working capital. Liquidity ratios and cash conversion cycle.

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For liquidity ratios, the current ratio and quick ratio is used. A current ratio of 2:1 is considered adequate for entities. However, if it is less or higher than 2:1, the company is not managing its working capital properly. Moreover, a quick ratio of 1:1 is said to be sufficient.

Cash conversion cycle or cash operating cycle shows the number of days between paying suppliers and receiving cash from debtors/customers. The entity should keep this cycle as low as possible. A longer period shows that the entity’s resources are tied down as either inventory in the warehouse or inability to recover cash from debtors.

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Study of the firm’s current assets: Another way to manage a firm’s working capital is to study its current assets. Current assets majorly include inventory, accounts receivables, cash and cash equivalent.

Inventory level should be monitored closely to avoid too many stocks in the firm’s warehouse. And to avoid not having enough inventory to meet customers demand.

Account receivables schedule should be prepared to know debtors that are yet to pay up their debts. There should be a limit to the amount of cash in the entity’s vault and at the bank. Any excess should be invested in cash equivalents such as treasury bills, fixed deposits and other short term funds.

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Study of the firm’s current liabilities: The company should also watch out for its current liabilities. It should avoid using excessive short term debt to finance its current assets. However, it should consider a mix of short term and long term debt to finance its gross working capital.

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Conclusion

As a bottom line, management of working capital is important in every business. Excess working capital may lead to risk of profitability while insufficient one may lead to liquidity risk.

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