What is Working Capital Management? Why it is important to business


As you all know, finance is the lifeblood of any business. Any business concern whether it is big or small it needs working capital to meet its day to day business operations. Without working capital, you cannot run your business successfully. Therefore, the smooth conduct of business is possible only with the maintenance of adequate amount of working capital.

working-capitalWhat is working capital?

Working capital is the amount which is required for meeting day to day transactions of the business concern which includes purchasing of raw material, making routine payments, meeting expenses relating to salary, wages, rent, advertising etc.., It is the measure of both the efficiency and short-term financial health of a company. Working capital is also known as floating capital or circulating capital.

How to calculate working capital?

Working capital can be calculated using a simple formula which is,

Working capital= Current assets- Current Liabilities

Current assets are short-term assets which can be converted into cash within a year. Examples of current assets include;

Cash and Cash Equivalents

Cash is the actual currency that is used for meeting daily transactions, while cash equivalents are like short-term investments which will mature or will be converted into cash within the period of 3months.

Short-term investments

Short-term investments are an asset which can be converted into cash within 1year. Both risk and return are low in case of short-term investments. Examples of some short-term investments are;

  • Savings account- An account which allows you to deposit and invest money for a short period of time.
  • Certificate of Deposit (CD)- It is a savings certificate which is issued by a bank to a person who deposits money for a specified period with a specified rate of interest.
  • Money market funds- It is a mutual fund that invests only in money markets such as short-term debt instruments
  • Treasury bills- It is a government security which is issued at a discount on its purchase price with no interest rates. It has a maturity of less than a year.

Receivables

It is the amount overdue which has to be paid by the customers to a company for a particular period of time. In other words, it offers credit to the customers.

Inventories

The term “inventory” refers to the stock of goods (raw materials, work-in-progress, finished goods) which are kept ready for sale.

Prepaid expenses

Prepaid expenses are the expenses which are paid in advance instead of paying it in future.

Current Liabilities

Current liabilities are the liabilities which must be paid to the creditors within 1year. Examples of current liabilities include:

Short-term debt

Short-term debt is a debt incurred by a company which must be paid within 1 year.

Accounts payable

It is the amount due made by a company to its creditors for purchasing goods on credit.

Accrued expenses

Accrued expenses are the expenses which have been incurred but not yet paid.

Interest payable

Interest payable is an expense which has been incurred but not yet paid. It is also the record of how much interest that has paid on investments.

Bank Overdraft

Bank allows customers to get a credit up to a maximum limit. If it goes beyond the limit, then it becomes overdraft and treated as a liability.

Why is working capital important for a business?

Working capital is very important because it is the measure of financial stability and efficiency of a business concern. It should neither be inadequate nor be surplus. Proper management of working capital should be ensured to maintain a balance between growth, profitability, and liquidity of a business concern.

The main reasons why working capital is important for a business are listed below.

  • Working capital helps in increasing the efficiency of a business with the smooth flow of production.
  • Working capital ensures flexibility and stability for a business concern.
  • The sound working capital position helps in increasing the reputation of a business concern.
  • Working capital helps in ensuring regular payment of dividend to its shareholders.
  • Sound working capital helps to complete the operating cycle (raw material- work in progress-finished goods)  quickly. By this, the profitability of a business is increased.
  • An adequate amount of working capital enables a business firm to use the fixed assets more efficiently and effectively.
  • Maintenance of adequate amount of working capital helps you to save your business in emergency situations like depression, recession etc..,
  • Maintaining an adequate amount of working capital will help you to increase your credit score. Thereby, you can get loans easily.
  • Working capital helps in increasing the liquidity of a business concern.
  • Employees can get their salaries and wages regularly with the maintenance of adequate amount of working capital.
  • Business concern ensures security and confidence with the adequate amount of working capital.
  • Working capital helps in expanding the growth of the business.
  • Working capital helps you in paying off short-term expenses and debts.
  • Working capital is essential for maintaining a sufficient balance between current assets and current liabilities.

Working capital is very important for any business, without working capital, the business is not possible, Therefore, working capital should neither be too high or too low. An adequate amount of working capital is essential for smooth flow of business.

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