Importance of working capital management of an organization

Prasad Sachintha

In the midst of intense battle for survival, many manufacturing organizations are more concerned about various initiatives to reduce cost. Total production maintenance, learn manufacturing, six sigma are some key initiatives organizations have already taken to proceed with less investment. Hence, managers are playing a very critical role in the process of cost reduction.

Since we are dealing in a liberalized, globalized and privatized world today, supply chain managers also play a cost effective role in the Sri Lankan manufacturing industry. Business organizations cannot play with the price anymore and in order to maximize profits reduction of the cost without compromising the quality of the product is essential. Therefore, our industries are badly in need of manufacturing managers with better financial knowledge. If manufacturing managers want to become learn practitioners, understanding the financial terms is a mandatory requirement.

In confronting the financial challenges that organizations may encounter, working capital plays an important role. Working capital it is the amount of money available to finance the day to day operations. It is important since it is an indicator of financial problems which act as an indicator of future financial shortcomings. Working capital also known as net working capital represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operation capital .It is the residual of current assets (assets which are expected to be realized in, or is held for sale or consumption in, the normal course of the enterprise's operating cycle) once all current liabilities (Liabilities which are expected to be settled in, the normal course of the enterprise's operating cycle) are settled. Thus, when current assets fall short of current liabilities, an entity has a working capital deficiency.

A company may possess assets and gain profitability, but if there are liquidity problems, it reflect that company has difficulties in converting their assets into cash in the normal course of the business at a negligible amount of cost. Positive working capital is required to ensure that a firm is able to continue it's operations and that it has sufficient funds to satisfy both maturing short term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivables, payables and cash. These components provide the sources of income for the business, whether in the form of profit from the sale products and services or interest earned from security investments. The current liabilities consist mainly of accounts payable which is of prime importance as management of payable can significantly affect cash flows of the company.

Effective working capital management is ensuring sufficient cash flow to fund business operations while reducing debt. Working capital management is the responsibility of the departments in organizations finance, sales, purchasing, planning, manufacturing and etc. When we are concerning about the working capital management (WCM) liquidity and profitability are two important aspects as there is a tradeoff between them. Company should maintain adequate liquid assets (cash in bank) within the company to settle the short term obligations and meet daily expenses while in contrast, company should also invest their funds in investments yielding greater returns to generate profits or either invests in inventory in the process of creating shareholder wealth which cause a reduction in the liquid assets.

Thus, the tradeoff between liquidity and profitability arisesi.e once liquidity is high profitability low and vise versa. Therefore, managing this tradeoff is somewhat challenging for organizations. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both short term debts and upcoming operational expenses. Businesses face ever increasing pressure on costs and financing requirements as a result of intensified competition on globalized markets when seeking to attain greater efficiency, it is important not to focus exclusively on income and expense items, but also take into account capital structure whose improvement can free up valuable financial resources.Managing Inventory means achieving minimum cost for inventory while ensuring that the company has adequate inventory to smoothen the production process. For this purpose, Economic Order Quantity (EOQ) can be used which is the optimum inventory level which minimizes both the cost of holding and ordering inventory. Re-order level can also be used to ensure that inventory is readily available for production. It is the inventory level at which the company should place the order for next batch of inventory at the amount equivalent to EOQ. In addition, companies should always maintain a buffer stock (minimum inventory level) in order to meet up with unexpected increases in production.

Trade receivables can be managed suitably, by having a well established credit policy for the organization. It will enable the company to evaluate customers for their credit worthiness before entering into contract with them.

Based on the credit worthiness amount (how much credit) and duration (credit period) will be determined. To managing debtors, proper collection procedure should also be implemented. This includes, on time collection, early settled discount, sending reminders and etc.

Managing creditors is also equally important as managing debtors. It is obtained through early discounts schemes by paying/settling down the credit before the due date. It gains the ability for the company to bargain for longer credit periods & higher credits.

In addition, cash management is a critical area for companies since they should decide the optimum cash balance to be maintained in their accounts.

Working capital cycle

Working capital cycle measures the time between payment for goods supplied and the final receipt of cash from sales. It is desirable to keep the cycle as short as possible as it increases the effectiveness of working capital.

A typical working capital cycle (WCC) is having four steps; they are cash, Trade payables, Inventories and trade receivables. The activities regarding these four aspects having an impaction WCC. Starting from inventories, inventories are purchased on credit which creates trade payables. These credit purchased may help with cash flows as there's no immediate to pay for these inventories. The inventories purchased are converted in to sales, on credit creating trade receivables. This means there's no cash inflows, even though inventory has been sold. The cash for the inventory sold, will be received later. Once the cash is collected from the trade receivables, the trade payables are needed to be paid. Unless, there will problems in the cash flow.

Striking a balance between levels of inventories and trade receivables has to be ensured, as the assets tie up fund, while giving no returns. In other words, they always include an opportunity cost for the company.

It is important to notice that excessive WC means too much money is invested in inventories and trade receivables. This represent last interest or excessive interest paid and lost opportunities which could yield higher returns.

On the other hand, managers must be keen to keep the WCC as shorter as possible as it means. Inventories are moving through the organization rapidly, trade receivables are being collected quickly and the organization is talking the maximum credit possible from the suppliers.

The excessive WC, is termed as over capitalization harden the effective of use of WC.

Every business should be concerned to maintain adequate WC to run its business operation. It should have neither redundant nor excess WC non inadequate or shortage of WC. Both excess as well as shortage of WC situations are bad for any businesses.

However out of two, inadequacy or shortage of WC is more dangerous from the point of view of the firm. Hence, a capital WC policy is the secret behind a successively managed working capital of an organization which result in effective and efficient business.