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Why should Working Capital be managed efficiently

Updated on August 29, 2016

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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    • profile image

      Driving for Life Nottingham 

      3 years ago

      Very good and interesting read, really technical and detailed, well done

      Javid

      http://drivingforlife.co.uk

    • profile image

      TheBizWhiz 

      3 years ago

      This is a very informative and detailed Hub. Thanks for sharing!

    • LasanthaW profile imageAUTHOR

      Lasantha Wijesekera 

      3 years ago from Sri Lanka

      Thanks for all your comments.

    • profile image

      Johnd102 

      3 years ago

      Really great info can be found on site. degfegkfdbeb

    • profile image

      nabial 

      5 years ago

      well done

    • profile image

      Lyaysan 

      5 years ago

      You can always tell an expert! Thanks for couriibnttng.

    • profile image

      Maria 

      5 years ago

      Do you know why most crocheters in eeailrr eras held the crochet hook in their hand like a pencil? In the 1800s, this hand positioning was thought to be more feminine and graceful. Many crocheters now hold their hooks in the palms of their hands (often called the knife hold ) to reduce carpal tunnel. I thought this was interesting! Thanks for sharing Jayna:)

    • profile image

      Dimitri 

      5 years ago

      guys i heard that for now its 13 buts later could get the other 9.Lets be honest if it is a full sesaon its even worst for chad and hilarie to coming back would be almost 2 years that they left the show more time that pass more worst for them to return and with a full sesaon they will have budget cuts so honestly lets move on ,get over it and who wants them at brooke wedding aceppt the fact that leyton will not be there and that you will get an excuse that they could not make it like happened in naley and leyton weddings with there parentes

    • profile image

      mohammed imran 

      5 years ago

      hats off to u sir lots of technicals of working cap management has been

      learnt thru u to improve ones business

    • profile image

      Miriam Marimbe 

      6 years ago

      Lasantha thanks for explaining well on this topic, so does this mean that a favourable working capital is 2:1.

    • LasanthaW profile imageAUTHOR

      Lasantha Wijesekera 

      7 years ago from Sri Lanka

      Thanks Heart4theword for understanding the correct position.

    • heart4theword profile image

      heart4theword 

      7 years ago from hub

      Wow Lasantha, I am so happy to hear...it was a misunderstanding on my part! Thank you so much for clearing things up for me! We are allot alike I think, in the fact that we want to be helpful to others..and not to offend! So glad, we are hub-friends! You have made my day complete, with your encouraging words:) Hugs!!!!!

    • LasanthaW profile imageAUTHOR

      Lasantha Wijesekera 

      7 years ago from Sri Lanka

      No!. Definitely not, Heart4theword. You have never insulted me or anybody else. You have not done anything wrong, for me to forgive you. You have never given any wrong impression. But in your comment you had praised my work and definitely you have encouraged me to do more hubs like this.

      I think you have misunderstood my comment. What I said in my comment was that a country like USA does not require the services of small people like me. USA has lot of expert financial people. You may not be a finance person. But from your work, I can understand that you are an expert in your own field because you have published some great hubs. That’s why I said “people like you are there” in my comment.

      So there is nothing to worry about my friend. Thanks for writing again.

    • heart4theword profile image

      heart4theword 

      7 years ago from hub

      LasanthaW, not sure what just happened here...yet I realized when you said.."People like you are there?" That there must have been a mis-interpretation, in my comments? There was nothing insulting intended by my response to your hub. Only the highest compliment to you..in what you do, and how you put this hubpage together. I myself, am struggling in the area of paperwork, and putting things in order. (Have had a hard time finding people, who know what they are doing in this field..to guide and direct people with their finances.) I was impressed by your experience and advice. So please..forgive me, if I gave you the wrong impression. I only meant blessings, and good to you!

    • LasanthaW profile imageAUTHOR

      Lasantha Wijesekera 

      7 years ago from Sri Lanka

      Thanks so much Heart4theword for your nice and encouraging comments. I hope that my service is not required by US because people like you are there. Anyway thanks again for your comments.

    • heart4theword profile image

      heart4theword 

      7 years ago from hub

      Liked what I was reading! You are very intellectual:) It seems you are very precise in your line of work, just from the way you put this hub together. Be nice if you lived in the states:), yet a good financial planner is needed everywhere!

    • LasanthaW profile imageAUTHOR

      Lasantha Wijesekera 

      7 years ago from Sri Lanka

      Thanks msms for your comments.

      Year as a professional accountant I always prefer to touch this type of topics. Also, as business managers or businessmen, it is very important to manage working capital of our businesses efficiently from the point of view of both liquidity and profitability. When it is managed in a poor manner, funds may be tied up in idle assets unnecessarily and it will reduce liquidity and profitability.

    • msms profile image

      msms 

      7 years ago

      Dear 'LasanthaW' from Shri Lanka - Thanks for touching the technical topic of working capital management. Though it is country and economic specific subject matter of significance but you have well explained to every person. Great Art 'LasanthaW' and thanks

    • LasanthaW profile imageAUTHOR

      Lasantha Wijesekera 

      8 years ago from Sri Lanka

      Thanks Springboard for your comments. As you said companies must keep sufficient cash for rainy season. But too much cash also shows the inefficiency of the management. If the company doesn't have any opportunity to invest surplus cash, it should be returned to the owners of the company.

    • Springboard profile image

      Springboard 

      8 years ago from Wisconsin

      I always love companies who have cash, and manage it well, and for all of the reasons you stated. Just like I don't like to live on large amounts of debt, I don't think it is a sound practice for comapanies to either. Keep cash on hand for rainy days. They happen. And when they do, being prepared IS your edge against the competition.

      Cash, working capitol. It's the same to me.

    working

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