Working Capital Management Manages Flow of Funds
Liquidity to Meet Day-to-Day Expenses and Liabilities is the Goal
Feb 14, 2009
Raw materials and operating supplies must be bought and stored to ensure uninterrupted production. Wages, salaries, utility charges and other incidentals must be paid for converting the materials into finished products. Customers must be allowed a credit period that is standard in the business. Only at the end of this cycle does cash flow in again.
Working Capital Management Approach
Essentially, working capital management involves:
- Ratio Analysis: Ratios such as Working Capital Ratio, Inventory Turnover Ratio and Receivables Collection Ratio can focus attention on problem areas for management action
- Managing Different Components: Specific solutions are available to manage the individual components of working capital such as inventory, receivables, cash and financing
Managing Working Capital Components
Management of associated cash inflows and outflows is the basic aim of managing each of the components. Selected solutions must result in acceptable cash flows, and also produce a return in excess of costs.
Inventory Management: Inventories of materials are needed to ensure smooth flow of production. Inventories need money to buy, space to store and wages to handle. On the other hand, if you purchase too low quantities, the frequency of orders and incidental material handling costs go up. So you have to identify an economic order quantity that balances the costs. Solutions such as SCM and Just in Time procurement have also been developed to manage inventories.
Receivables Management: Giving credit has become a standard business practice and it means that collection of cash from customers has to be postponed. Offering discounts to customers who pay promptly (within 10 days, for example) and accounts receivable funding through factoring operations are some important ways to manage receivables.
Cash Management: Cash in the till does not earn any income. On the other hand it can help:
- To exploit opportunities for short-term profitable deployment,
- Meet maturing liabilities if expected inflows do not materialize and
- Ensure uninterrupted completion of day-to-day transactions.
Considering these factors, policies are developed for the amount of cash balance to be maintained at all times.
Short-Term Financing: Supplier credit is a significant source of working capital finance. You can buy raw materials and use it for 60 or so days before paying for it. During this period you might be able to produce and sell products, and generate funds to pay the supplier in part. The factoring operations mentioned earlier can generate additional funds. Any remaining shortfall is typically financed with short-term bank loans or lines of credit (where you draw funds only if and when needed).
Cash Flow Forecasts: Cash flow forecasts are prepared to estimate cash outflows and inflows, and identify the timing and extent of shortfalls in funds availability. Based on these estimates, bank finance or other funding options can be arranged in time.
Working capital is distinct from fixed capital in that it is short-term in nature. There is no long-term commitment of funds. As against this, even a short-term liquidity problem can affect the profitability of the business. If the liquidity problem persists, the very survival of the business can be in danger. This is why working capital management has become a critical function.
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