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What is Working Capital Management? Importance, Components, and Benefits

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Working capital management plays a very important role in the success of any business venture. More and more companies that are running into losses or struggling financially will be profitable and liquid. The working capital management system helps you determine whether productive capital can be held for productive uses. Many finance professionals & business experts often ignore the importance of this management. It is an effective management technology tool that has the potential to guarantee long-term success.

# What is Working Capital Management?

Working capital management is a business tool that helps companies to make effective use of their current executives. It helps companies maintain a sufficient amount of flow to meet lower targets. By managing an executive effectively, companies may be at risk of being free otherwise stuck on their balance sheets. As a result, they may be able to reduce the need for external lending, expand their businesses, merge or acquire funds, or invest in R&D. It forms part of the total capital of the company. This capital is required by all businesses to meet their short-term requirements and is an important part of current assets.

# How is Working Capital Calculated?

The working capital formula is: Working capital = Current Assets – Current Liabilities.

The working capital formula tells us that short-term liquid assets have been repaid after short-term liabilities. It is a measure of the short-term liquidity of a company and is important for financial analysis, financial modeling, and cash flow management.

# What is Effective Working Capital Management?

Effective working capital management encompasses many aspects of short-term finance such as: maintaining adequate levels of cash, converting short-term asset (ie, receivable and inventory) accounts into cash, and approving outgoing payments control to vendors, employees, and others. To do this successfully, companies invest short-term funds in working capital portfolios of short-dated, highly liquid securities, or they may issue loans or finance as lines of bank financing by issuing commercial paper or other money market instruments. In simple words, efficient working capital management means ensuring sufficient liquidity in the business to be able to meet short-term expenses and debts.

# Working Capital Management Solutions

Most companies are using a wide range of multiple solutions to support effective working capital management for themselves & their products. Such as:

  • Electronic invoicing:- Presenting electronic invoices in managing current funds can help companies a lot in achieving working capital gains. By streamlining invoicing, you can reduce the risk of errors in your company, automate manual processes, and you can easily ensure that your customers receive the invoice as soon as possible so that they can pay soon. Methods of submitting electronic invoices can enable companies to automatically initiate purchase orders in invoices or to present high volumes of invoices using system-to-system integration.

  • Cash flow forecasting:- By predicting future cash flows – such as payments and receivables – companies can plan for any subsequent cash gaps and make better use of any surpluses. With this, you can more accurately predict your future cash flow, which will give you better insight into even more working capital management decisions.

  • Dynamic discounting:- It is a solution that you can use to provide initial payment to buyers & suppliers. But this time there is no external fund, as the program is funded by the buyer through an early payment discount. Like supply chain finance, it also enables suppliers to reduce their days’ sales outstanding (DSOs). Or, it allows buyers to get an attractive risk-free return on their surplus cash.

  • Supply chain finance:- For buyers, supply chain finance also is known as reverse factoring. It is a way for suppliers to offer prompt payment through one or more third-party funds. Suppliers can improve their DSO by paying early at a lower cost of money while buyers can conserve their working capital by paying according to agreed payment terms.

  • Flexible funding:- Working capital providers who offer flexible funding. They can allow buyers to move fundamentally between supply chain finance and the dynamic discount model, meaning that companies can adapt to their changing working capital requirements to support their suppliers.

# Importance of Working Capital Management

Working capital management requires sufficient cash flow to perform its daily tasks. Such as making payments, purchasing raw materials, or managing unexpected expenses. The working capital business plays an important role in meeting all these requirements and also serves as a report card for the financial management of the company. Proper working capital management facilitates the business to operate smoothly and improve its earnings.

This includes proper management of inventory, accounts receivable, and accounts payable so that sufficient cash is available regularly operations, this is an accounting strategy that not only helps businesses meet and enhance their financial obligations. It also helps identify areas of the business that need height to maintain profitability and liquidity.

# Advantages of Working Capital Management

  • It is helpful in attracting new customers, refreshing the brand, increasing online presence, creating marketing capital for event sponsorship, direct marketing campaigns, and more.

  • It helps prevent payment delays and manages cash flow for significant operating expenses such as payroll, keeping utility current, payments of leases or mortgages, and more.

  • It is useful to purchase additional inventory needed to fill future orders, restock your inventory, buy new products, etc., and expand the business infrastructure.

  • Useful in advance payment when you want to take advantage of wholesale pricing for the update tool.

  • Ideal for seasonal businesses to restore inventory in the off-season, hire temporary employees, promote accurate marketing, cover expenses such as rent, insurance, taxes, salaries, and more.

  • Especially useful to meet unexpected and unforeseen expenses.

# Disadvantages of Working Capital Management

  • Additional working capital with the company does not earn any interest for the company.

  • There is a possibility of overspending or purchasing unnecessary things for the business.

  • Companies use working capital to finance long-term projects.

  • This strategy only takes into account monetary factors.

  • The working capital management policy is that it is not situational in nature.

# Components of Working Capital Management

  • Inventory Management:-  Inventory is goods that are bought by a company for the purpose of selling in the market and making a profit. The turnover of our inventory determines how successful our business is. Inventory is basically purchased from raw materials, WIP products, and manufactured goods or suppliers. Where the company buys an excessive stock and places a heavy burden on finance. Similarly, if the inventory is not available on time, it is a loss of sales. Therefore, inventory management involves the control of stock that is purchased for sale in the normal course of business. Read more about Inventory Management. 

  • Accounts Receivable:- Account receivable is the amount received by customers in the normal course of business due to credit sales by the company. You will find accounts receivable on the company’s balance sheet under current assets. The important point is that they are classified as assets but in real terms, they are not available for use until they are realized in a more liquid form. It is an important component of working capital management and must be managed efficiently to improve the financial health of the company’s operations. Read more about Account Receivable.

  • Accounts Payable:- Once you have established your current accounts receivable, it is payable to view your accounts. Accounts payable is practically the opposite of your accounts receivable. Accounts payable are the obligations of the company to pay its debts to its creditors and suppliers. Liabilities payable come under the head of current liabilities and are one of the major components of working capital management. Accounts payable can be managed through negotiations with creditors to extend the due period. Read more about Account Payable.

  • Cash and Cash Equivalents:- These are the most important current assets that are managed under working capital management. Being the most liquid form of assets, we must manage it effectively and efficiently to maintain the financial stability of the company, meet unexpected expenses and handle regular operating expenses on time. Apart from this, managing cash properly also helps in maintaining the rating of the company and protecting the company from insolvency.

# Types of Working Capital Management Ratios

Working capital management uses these ratios to measure the liquidity of an organization.

  • Current Ratio:- The current ratio, which we also call the working capital ratio. It measures the availability of sufficient resources to meet its short-term obligations. In other ways, it states readily available cash to meet your daily obligations. The formula for calculating the current ratio is: Working Capital Ratio = Current Assets / Current Liabilities

  • Inventory turnover Ratio:- Inventory is a huge working capital and that’s why businesses need to measure how well inventions are used. The inventory turnover ratio measures how many times a company has sold and changed inventory over a given period of time. The formula to measure inventory turnover ratio is: Inventory turnover ratio = Sales / closing stock

  • Collection Ratio: – The collection ratio indicates the turnover receivable in days. This tells you the entire average time taken by your customer to pay. This ratio helps you identify customers who have a poor payment record. The formula for calculating the collection ratio is: Collection ratio = Receivable / Total sales x 365 days.

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