By Soham Aher. Edited by Swastik Patel.
Working capital management refers to a company’s efforts to ensure it has adequate resources for day-to-day running expenditures while maintaining resources invested in a profitable manner.
Goals of Working Capital Management
Working capital management’s major objective is to help the business maintain enough cash flow to cover its short-term operational expenses and short-term debt commitments. Working capital is the difference between a company’s current assets and current liabilities.
The net operating cycle (NOC), often referred to as the cash conversion cycle (CCC), is the lowest length of time necessary to convert net current assets and liabilities into cash. Working capital management supports maintaining the NOC’s smooth functioning.
Through the effective use of its resources, working capital management may enhance a company’s cash flow management and earnings quality. Inventory management, accounts receivable and payable management, and accounts payable management are all included in working capital management. The timeliness of accounts payable is another aspect of working capital management (i.e., paying suppliers). A business may manage its working capital by deciding to extend supplier payments and to make the most of available credit, or it can spend money by making cash purchases.
Profitability is the other main goal. Working capital investments typically produce little or no return. As a result, a business with a high amount of working capital may not generate the operating profit minus the sum of its long-term liabilities that its investors had anticipated. Therefore, there is a trade-off between liquidity and profitability when deciding on the right quantity of working capital.
Factors That Affect Working Capital Needs
Working capital needs are not the same for every company. The factors that can affect working capital needs can be endogenous or exogenous.
Endogenous factors include a company’s size, structure, and strategy.
Exogenous factors include the access and availability of banking services, level of interest rates, type of industry and products or services sold, macroeconomic conditions, and the size, number, and strategy of the company’s competitors.
The goal of inventory management is to ensure that the business maintains an acceptable quantity of inventory to handle daily operations and demand changes without placing an excessive amount of money into the asset. A high inventory level indicates that it has a high capital commitment. Additionally, it raises the possibility of unsold inventory and eventual obsolescence depreciating inventory value. Another reason that a stockpile deficit should be avoided is because it would result in lost revenue for the business.
In conclusion, working capital represents the net current assets available for day-to-day operating activities, and its goals are to maintain sufficient cash flow and profitability of the business.