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Why should Working Capital be managed efficiently
Working Capital means the capital available for running the day-to-day operations of an organization. It is the excess of current assets over current liabilities. In other words, working capital is the excess of permanent capital plus long term liabilities over the fixed assets of a company.
The control of working capital can be divided into areas dealing with inventory, receivables, payables and cash. In order to continue trading, an organization should be in a position to meet its immediate obligations. Therefore, sufficient cash must be generated by the organization. Even the most profitable business can quickly go under if it does not have sufficient liquid resources. But an unprofitable company can survive for quite some time if it has sufficient liquid resources. This means, working capital is essential for the organization’s long term success and development. The greater the extent to which current assets cover the current liabilities, the more solvent the organization.
It is very important to manage working capital efficiently. This is important from the point of view of both liquidity and profitability. When there is a poor management of working capital, funds may be unnecessarily tied up in idle assets. This will reduce liquidity of the company and also the company will not be in a position to invest in productive assets like plant and machinery. It will affect profitability of the company.
Every organization should budget an appropriate amount of working capital to meet its anticipated future needs. If this is not done properly, the organization will be unable to meet its liabilities as they fall due. This is a situation where the relevant organization is said to be technically insolvent. The amount of working capital required by an organization will depend on many factors like the type of business activity, credit policy of the organization, promotional activities, time period of the year and many others. In uncertain conditions, organizations must hold a minimal level of cash and inventories based of expected revenue. An additional safety buffer should also be added to this amount.
There are three working capital management policies adopted by companies.
- Aggressive policy
- Conservative policy
- Moderate policy
With an aggressive working capital policy, organization holds a minimal level of inventory. Therefore, aggressive policy would minimize costs. But the organization may not be able to respond rapidly to increases in demand because of the low stocks. Companies adopting an aggressive working capital financing policy, finance part of its permanent asset base with short term debt. Because cost of short term debt is generally less than the cost of long term debt, aggressive working capital policy provides the highest return but it is still very risky.
A large inventory is maintained under the conservative policy and therefore the return is lower than under an aggressive policy. In terms of risk and return, a moderate policy falls somewhere between the two extremes. Under a conservative working capital financing policy, the organization’s non-current assets, permanent current assets as well as a part of the fluctuating current assets are financed with permanent financing (equity and long term debt). Therefore the conservative financing policy is the least risky policy but it gives lowest return to the company.
With a moderate working capital financing policy, non-current assets and permanent current assets are financed with permanent finance and only the fluctuating current assets are financed with short term debt.
You may be aware that cash, inventories and receivables are all current assets that form part of working capital. But there is a basic difference between cash and inventories on one hand and receivables on the other. Higher level of cash and inventories means a safety buffer and therefore it is a more conservative situation. In the case of receivables, there is no such thing as a safety buffer of receivables. A higher level of receivables generally means that the company extends credit on more liberal terms. Aggressive working capital policy has been identified above as risky. Then lowering inventories and cash would be aggressive but increasing receivables would also be aggressive.
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