So that there is a happy medium between liquidity and profit, the finance manager needs to formulate a sound policy for managing working capital. The structural viability of a business is profoundly affected by how well its working capital is managed. The current and liquid ratios may show that the firm is liquid if the various components of working capital are in balance; however, the firm may not be as liquid as represented by the current and liquid ratios. Inventory or slow-moving/outdated products cannot serve as a cash buffer if they make up a sizable share of current assets. Check out these sources of working capital in financial management to broaden your horizons.
Managing a company’s current assets and liabilities is the best definition of working capital management. It takes a look at the problems that can occur in the management of present resources and obligations and how they are related to one another. Managing a company’s current assets and current liabilities to keep a comfortable level of working capital — not too little, not too much — is the primary goal of working capital management. Having too little or too much money on hand is dangerous. Production could halt if there isn’t enough money on hand. For a complete understanding of the objectives of financial management topic, read on.
Sources of Working Capital in Financial Management
A company can’t function without a steady infusion of working capital. Increasing your company’s working capital can help it run more smoothly, but doing so requires careful management. It is critical for businesses to have enough cash on hand to pay for expected and unexpected costs, and for expansion purposes. Careful management of cash flow, receivables, inventory, and investments achieves this. Protecting the company’s continued existence and viability as a business hinges on making sure it has the funds it needs to run normally each day. Also, lack of cash, poorly managed commercial credit practices, or limited access to short-term funding can force a company to reorganize, liquidate assets, or close its doors. Here is an overview of sources of working capital in financial management with a detailed explanation for your convenience.
Payout Strategy
The company pays dividends out of its profits, resulting in money leaving the business. Earnings and dividend payments are what establish a company’s level of working capital. Money in circulation grows when the net profit margin is high. Distributing a sizable chunk of earnings as dividend payments reduces a company’s liquid assets. The dividend policy of a corporation can have a significant impact on the need for new operational capital.
Revenues Withheld
Deferred income refers to money earned before providing goods or services. They reveal the sum of money an organization made by selling its products or services to potential customers. These funds are crucial for the company’s short-term finance needs and help with cash flow. Firms who have established themselves successfully in the marketplace and whose offerings are in high demand may, however, ask for payment delays.
Controlling Stocks
The goal of inventory management is to keep costs down while maintaining a stockpile large enough to meet routine operations and changes in customer demand. Too much capital has been put into anything if there is an excess of it. It also raises the prospect of some stock not moving or losing value due to obsolescence. It’s also important to prevent shortages of stock, which can lead to financial hardship for the organization. External sources of working capital in financial management include short-term loans and lines of credit obtained from financial institutions.
Credit in Trade
Trade credit is the provision of credit by a seller to a buyer in order to facilitate the sale of goods. Companies rely heavily on credit, making trade credit arrangements with their suppliers an essential source of working capital funding. A company’s ability to obtain trade credit is predicated on the faith of its suppliers in its financial stability.
Business Paper
Promissory notes in the form of commercial paper do not carry any collateral. It’s a common way for companies to get their hands on some quick cash. It is an essential part of the monetary system in developed countries like the United States. The RBI included commercial paper in the Indian money market upon the recommendation of the Vague Committee. Commercial paper is a quick and easy way for major companies to get cash, but only if they have good credit and are financially stable. Most commercial paper issued in India has a maturity date between 91 and 180 days from the date of issuance.
Loans and Financial Institutions
Some companies offer their agents and consumers cash advances in exchange for orders. This helps them get the money they need to run their business. It’s a low-cost strategy for making money. Short-term funds are mostly provided by commercial entities. Commercial banks typically offer the most readily available working capital loans. They have several kinds of loans for different kinds of businesses. Trade credit, where suppliers extend credit terms to the company, is another important source of working capital in financial management.
Native American Bankers
Commercial banks replaced the need for access to cash solely through individual money managers and other forms of nation banking. They used to demand outrageous interest rates and take advantage of their clients in every way. Commercial banks are no longer a monopoly because of the proliferation of new institutions. Local bankers are still the go-to for certain companies when they need a loan to cover their daily operations.
Payment Plan Loans
This is yet another option for getting what you want right now while spreading out the cost. Interest is either added to the outstanding balance or built into the cost. But it is a source of short-term operating financing for many organizations who are struggling with cash flow challenges.
Accounts Receivable Factoring
Another way to have access to quick cash is to take out a line of credit against your receivables. Trade and commercial banks offer this type of credit. A discount on bills or invoices is one way a commercial bank can lend money. The result is timely payment for goods and services sold on credit. A factor is a type of financial entity that helps with credit transaction financing and debt management. Equity financing, such as issuing new shares or attracting investments from shareholders, can provide additional working capital in financial management.
Receivables Management
Businesses need to create sufficient cash flow from their operations while also providing sufficient leeway or commercial credit to their customers. The creditworthiness of the borrower, the company’s lending practices, and the actual lending practices of competitors will all factor into the loan’s terms. Standard credit terms provide consumers 30 to 90 days to settle their payments. Depending on the company’s policies and the manager’s discretion, it may be essential to use other payment terms, such as cash before delivery, cash on delivery, bill-to-bill, or recurring invoicing.
Short-Term Debt Management
Short-term finance management aims to minimize risk exposure and meet short-term obligations, similar to liquidity management. Selecting the right financial instruments and figuring out how much money can be earned through each is the best way to handle short-term finances. Popular ways to raise capital include credit lines, uncommitted lines, rotating credit agreements, collateralized loans, discounted receivables, and factoring. A business needs to make sure it has enough cash on hand to cover its costs during busy periods. A business, for instance, can set up a revolving credit agreement with terms that are far more generous than what are needed on a regular basis.
Controlling Cash Flow
In order to meet both its expected and unexpected expenses, a corporation must practice good liquidity management. Its importance stems from the fact that a company’s reputation may make or break its fortunes. If all else is equal, a corporation is more likely to run into financial trouble the less liquid it is. Poor resource management may be indicated, however, if a disproportionate quantity of funds are invested in activities that do not produce a satisfactory return. Sufficient cash on hand and/or the ability to swiftly and readily develop cash resources to meet business needs are signs of good liquidity management. Bank overdrafts provide a flexible source of working capital in financial management, allowing the company to withdraw more funds than available in its account.
FAQ
Why is it Important to have Working Capital?
Your company’s capacity to pay employees and vendors, keep the lights on, and invest in long-term growth is all impacted by its level of working capital. Working capital, in a nutshell, consists of readily available funds that can be used to meet short-term liabilities.
Can Working Capital Ever be Negative?
The net amount of current assets is used in the calculation of working capital, however this number need not be positive. It might be zero or a negative number. As a result, a company’s bottom line can react in various ways to changes in its working capital.
What is the Primary Focus of Managing Working Capital?
Working capital management’s primary goals are to keep operations running smoothly, incur minimal costs, and maximize returns on investments in current assets.
Summary
To guarantee that the company has enough cash on hand to pay its short-term operating expenses and debt commitments, it must engage in working capital management. As part of effective working capital management, one must monitor ratios such as the working capital ratio, payment ratio, and inventory ratio. Effective working capital management can improve a company’s cash flow and the quality of its earnings. When performing various business tasks, keep in mind that sources of working capital in financial management plays an important role in the overall process.
