Question

How does a firm manages its working capital and why it is important? Please provide example.

Answer 1

Hi,

Managing Working Capital

Regardless of Size of firm, working capital management is equally important for every organisation. Working Capital means Net Current Asset of a business (Current Asset - Current Liabilities). It depicts Short term liquidity of a business. So, it is important for every business to manage it's working capital. Here are some ways by which firm manages it's working capital:-

1. Improve Receivable Process:- The Receivable process includes generating invoice and collection from Debtors. The Receivable process period should be as less as it could be. For this firm should generate invoice as soon as goods are delivered and assess it's Receivable process in order to eliminate delays in collection. For Example:- If an organisation have to send invoice to supllier then it must be approved by Accounts department head, Head of Finance Department and CEO of the company. This Process seems to be ineffective so, instead of taking approval from 3 heads, an organisation should make policy to aprrove it only by finance department head, it will be effective and delays will be reduced.
2. Pay Vendor on time:- A Business must pay dues to supplier on time to reduce it's current liability and increase working Capital. Paying supplier on time also helps creating healthy relationship with supplier which furthur help in negotiation with supplier. For example:- ABC Ltd. have to pay $50000 to it's vendor Mr. David within 30 days. But ABC Ltd. defaulted in payment and pays after 60 days. Then the relation between Daivd and ABC Ltd. will not be good enough. So, when next time ABC Ltd. Purchase from David then David might not give discounts as he will think that ABC Ltd. always defaults in payment and as a result ABC Ltd. has to pay more cash and working Capital will decline.
3. Inventory Management:- A firm should keep an eye on stock so that there is no excessive holding of stock which will block capital of the firm. The firm should maintain optimum level of stock and evaluate re-ordering levels, so that it can order at perfect point of time. For Example:- A pen manufacturing company requires a raw material of plastic, the company produces 20,000 pens in 1 month and plastic required for 20,000 pen is 20kg (melted), but instead company procured 50kg of melted plastic. So, there will be excess stock and it will block capital by Price equivalent to 30kg.
4. Control on expenses:- A firm should monitor it's expenses on regular basis. Generally, large organisation ignores expenses which have adverse impact on working capital of that company. Huge Expense reduce working capital and impacts on profits of the company. For Example:- A company produces a good for which it requires 2 Labour Hour Per Unit. The company received an order of 50000 Unit of the product within 3 months. But due to negligence production manager doesn't produce it but at the end of 2 month it started producing and Labour has to work overtime to complete production within stipulated time, for which company has to incur huge overtime Expenses of Labour, due to which cost of good sold increase and result in decrease in working capital.

Importance of Working Capital:-

Managing Working capital is imporant due to follwoing reasons:-

1. Improved Credit Profile:- Credit Profile of any business is very crucial when it comes to finance the company. Any Lender / Investor will lend or invest only when credit score of the company is good enough. The company who pays on time to it's vendor has good credit Rating by Credit Rating Agencies and hence when it will raise money from any instrument people will trust due to good credit score.
2. Ability to face shocks and Peak Demand:- Efficient working capital will help provide liquidity in business while help business survive in times of crises and help them fulfill peak demand. For Example:- Due to Mortagage crises 2008 in USA many companies shut down due to illiquidity in their business which was due to inappropriate or mismanagement of working capital.

3. Increase Goodwill of Firm:-  A firm with sound working capital position can make timely payments to it's vendors which increase reputation of the company.

4. Increase in Morale of Employees:-  A firm with sound working capital can make regular and timely payment of wages and salaries to its employees. This increases the morale and efficiency of employees.

5. Efficient use of Fixed Assets:- Adequate amount of working capital enables the firm to use its fixed assets more efficiently. If the fixed assets remain idle due to lack of working capital, depreciation of fixed assets and interest on borrowed capital invested in fixed assets will have to be incurred unnecessarily. For Example:- A machinery has been set up to produce T-shirts. Let's say the actual demand is of 50 Tshirt in the month of November but due to mis management of working capital, raw material of only 10 T-shirts are available in the market and no stock is maintained (Due to bad Working Capital Management). So, raw material of only 10 T-Shirts have been processed in the machinery which leads to under utilisation of machinery and unnecesaary depreciation. Hence, Economies of Scale wouldn't be achieved.

Thanks!