Your working capital management skill will reflect in the liquidity of your business.
Before your read this article, I suggest you first read my previous article on “Preparation of Financial Statements for Your Business”. Without the knowledge of financial statements, it may be difficult to understand this article on working capital management. With your understanding of financial statements, it will not be difficult to quickly grasp the meaning of working capital. Working Capital refers to that part of the firm’s capital, which is required for financing short-term or current assets such as cash marketable securities, debtors and inventories. Working capital is the difference between organization’s current assets and its current liabilities. It is used to support the day to day financial operations of an organization.
We have two types of working capital namely (1) Permanent working capital and (2) Temporal working capital.
Permanent working capital
This is the portion of working capital that a company is expected to generate on a consistent and uninterrupted manner. Working capital is considered permanent to the extent that it supports constant minimum level of sales. Even though it is called permanent working capital, the amount involved cannot remain constant, For a growing business, permanent working capital will keep increasing as more funds will be needed to buy raw materials and to support work in progress and finished goods. On the other hand, if the business is declining, less amounts will be required as permanent working capital.
Temporal Working Capital
A firm is required to maintain an additional current asset temporarily over and above the permanent working capital to satisfy cyclical demands. Any additional working capital apart from permanent working capital required to support the changing production and sales activities is referred to as temporary or variable working capital. Temporary working capital is usually required to meet the unforeseen events like seasonal production, sudden price increase and other contingencies.
Relevance of Working Capital Management
So, what is the relevance of working capital to the success of your business? The goal of working capital management is to ensure that your business is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short term debt and upcoming operating expenses. Whatever type of business you may be doing, you need working capital to keep your operation running without interruption. For examples, you need working capital to replenish your inventories, pay staff salaries, utility bills and rent. Imagine what will happen to your business if you can’t pay rent, staff salaries or replenish your stock! The chances are that your landlord will evict you; staff morale will be low and this will affect their productivity; customers will go to another place where their needs can be catered for. Cash is the life blood of any business.
Profitability and liquidity are two different things. Having profitable business with no liquid cash can ground your entire business. In an attempt to make more profits, some companies invest almost all their cash resources leaving no or little cash as working capital. Such companies usually run into crisis. If it is not resolved on time, this can lead to the liquidation of such companies. I like what Warren Buffet said about the need for effective working capital management. He said,
“I have pledged – to you, the rating agencies and myself – to always run Berkshire with more than ample cash. We never want to count on the kindness of strangers in order to meet tomorrow’s obligations. When forced to choose, I will not trade even a night’s sleep for the chance of extra profits”.
That is how important the need for effective working capital management can be.
How much should you invest in Working Capital?
Even though working capital is essentially required to finance short term assets, from the explanation given above on the permanent working capital, you should understand that maintaining working capital balance requires permanent commitment of funds. The size and nature of investment in current assets is a function of different factors such as:
- Type of products manufactured,
- The length of operating cycle
- The sales level.
- Inventory policies
- Unexpected demand and unanticipated delays in obtaining new inventories.
- Credit policies and current assets requirements.
Other factors that may influence your working capital management include the nature of your business or industry, inflation, your current cash reserves, operation efficiency and your attitude toward risks.