Working capital is simply the difference between the current assets of the company: current assets may include stocks of raw materials, work-in-progress and finished goods, debtors, short-term investments and cash and the current liabilities of the company: trade creditors, overdrafts and short-term loans. A working capital decision is a short term decision and basically focuses on the ability of the organization to generate enough cash for its short-term needs. Working capital is also the measure of a company’s liquidity, operational efficiency, and short-term financial health.
|Current Liabilities||Current Assets|
|Bank Overdraft||Cash and Bank Balance|
|Creditors||Inventories: Raw-Materials, Work-in-progress, Finished Goods|
|Outstanding Expenses||Spare Parts|
|Bills Payable||Accounts Receivables|
|Short-term Loans||Bills Receivables|
|Proposed Dividends||Accrued Income|
|Provision for Taxation||Prepaid Expenses Short-term Investments|
There is no absolute value for the networking capital for any company. Positive working capital indicates that a company can fund its current operations and invest in future activities and growth. High working capital might indicate that the business has too much inventory or is not investing its excess cash i.e. reflects the operational efficiency.
Working Capital Policies
Working capital policies should be considered as per the nature of the company’s business since different businesses have different requirements for working capital. Along with it, working capital policies also need to reflect the credit policies of the company.
- Aggressive Policy
- Conservative Policy
- Moderate Policy
The aggressive approach is a high-risk strategy of working capital financing wherein shorter finances are utilized not only to finance the temporary working capital but also a reasonable part of the permanent working capital.
An aggressive policy with regard to the level of investment in working capital means that a company chooses to operate with lower levels of stock, debtors and cash for a given level of activity or sales. An aggressive policy will increase profitability since less cash will be tied up in current assets, but it will also increase risk since the possibility of cash shortages or running out of stock (stock-outs) is increased.
A conservative and more flexible working capital policy for a given level of turnover would be associated with maintaining a larger cash balance, perhaps even investing in short-term securities, offering more generous credit terms to customers and holding higher levels of stock. Such a policy will give rise to a lower risk of financial problems or stock problems, but at the expense of reducing profitability.
Under the conservative approach, the working capital is primarily financed by long term sources. The larger the portion of long term sources used for financing the working capital, the more conservative is said to be the working capital policy of the firm. In case, the firm has no temporary working capital need then the idle long term funds can be invested in marketable securities. This will help the firm to earn some income. The firm uses a small amount of short term sources to meet its peak level working capital needs. It also stores liquidity in the form of marketable securities in slack season.
A moderate policy would tread a middle path between the aggressive and conservative approaches. A moderate approach, which is also called hedging strategy, follows the matching principle. According to this approach, noncurrent assets should be financed by long-term financing and current assets by short-term financing. Therefore, under a moderate approach, businesses should use long-term financing to finance noncurrent assets and permanent working capital. The need for temporary working capital should be met by short-term financing.
Importance of Working capital management
Improved Credit Profile and Solvency
Working capital reflects the ability of the company to meet short-term obligations and it is one of the requirements for long-term solvency. Also, working capital indicates the position of credit risk associated. A well managed working capital will allow businesses to fulfill its short-term obligations and maintain solvency.
Payables and receivables in any businesses are the crucial factors that directly or indirectly impact the profitability of the business. Efficient working capital management helps in maintaining payables and receivables along with the other operations impacting the earnings and profitability of the organization.
Companies using low working capital can publish the best greater return on capital so that shareholders will always get advantage of high returns for all dollars invested in your business.
Working capital policies reflect the liquidity position of the company. The level of cash lets organizations be less dependent on external financing for their short-term obligation. Liquidity essentially measures its ability to pay off its liabilities when they are due, or how easily and effectively a company can access the money it needs to cover its debts. Working capital reflects the liquid assets a company utilizes to make such debt payments.
- Adequate working capital enables a concern to face business crisis in emergencies such as depression because during such periods, generally, there is much pressure on working capital.
- Adequacy of working capital creates an environment of security, confidence, and high morale and creates overall efficiency in a business.