Working capital is the key to a successful business. It is like their blood flow and the manager’s job is to help keep it flowing. Under the Generally Accepted Accounting Principles working capital is simply the difference between a company’s Current Assets, which are cash, inventory, accounts receivable and prepaid items, and Current Liabilities, accounts payable and accrued expenses. Working capital is of major importance to a business because it controls the current day-to-day operations including payment of salaries, wages, inventory, raw materials, other business expenses, purchase of stocks, buildings, land, fixed assets, etc.
A business firm must maintain an adequate level of working capital in order to run its business smoothly. It is worthy to note that both excessive and inadequate working capital positions are bad for business. Working capital is the heart of business. If it does not exist than the business cannot survive. You cannot run a business without proper working capital. As a business owner, you must constantly be alert to changes in working capital and their implications, if you don’t you might miss some of the warning signs and it can lead to the loss of business.
The most important component of working capital and the most important asset of a business is cash. Without cash a business will go under. That is why it is so vital for a business to have control over all cash transactions. Positive working capital means that the company is able to pay off its short-term liabilities. Negative working capital means that a company currently is unable to meet its short-term liabilities with its current assets (cash, accounts receivable, inventory). If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term.
This can lead to bankruptcy. A declining working capital over a longer time could also be a red flag that warrants further analysis Cash is the most liquid form of working capital and requires constant supervision. A business needs to have a good cash budgeting and forecasting system put into place so that it will provide the business with information throughout the year. If a company can stick to its budget then the working capital should be in good shape. Part of working capital is keeping track of the accounts receivables. This is a business’ billing process. A business needs to keep on top of this process nd make sure a customer is paying on time, paying the correct amount and getting billed properly. A business must also try to encourage a customer to pay early so the business has cash on hand and can invest earlier or pay any obligations that need to be paid on time. Inventory is a large part of a company’s current assets, so it requires a great deal of constant supervision. A company must make sure that the inventory is at a realistic level compared with sales and profit. A business must have a good inventory system in place. Depending on the nature of business a physical count should always be done at closing.
A company needs to have an inventory policy at hand. Should a roll forward procedure be done or should an adjustment be done at closing. Another area that a business needs to keep track of is their financing with their vendors. This is called accounts payable. A business must make sure they are getting the best deals from their suppliers and that they have the finances to pay them. The business must have policies put into place to make sure their employees follow them and are getting the best prices and that they are making wise decisions, does the company need these items?
Will they sell? You can find that out with the inventory process. If a company makes a wrong move with paying down their debt, their credit rating goes down and it affects the future of the business. If a company decreases the amount of accounts payables, keeping debt to a minimum, this will help the working capital become positive. Another aspect of working capital is made up of miscellaneous spending of prepaid expenses and accruals. Even though most of these expenses are not of big magnitude their value can add up and affect the company’s finances.
Some of these items are accrued time for employees, bonuses, benefits, utilities, improvements and taxes. Some additional sources of working capital include; cash reserves, profits, equity loans, line of credit, and long term loans. There are reasons that a company will have working capital problems. Some include; 1. Not enough sales to produce cash flow 2. Overdue accounts receivables increasing over time 3. Customer satisfaction is low 4. Increase in payroll 5. Inventory problems 6. Bad credit 7. Failing to pay on time and being able to claim discounts for prompt payment 8. Over purchasing and unnecessary spending
A manager must be on top of these problems and once found they must correct any of these issues as soon as possible. A simple monthly report should be able to show any problems with the working capital. To avoid the shortage of working capital, an estimate should be made in advance. The factors that should be considered to estimate working capital should be; the credit period expected to be allowed by a vendor, costs of material and wages of a project, the length of time that a product remains in a business, the length of the production and the period of credit allowed to a customer.
The factors that a company needs to take into consideration to determine their working capital requirements are; the nature of business, size of business, production policy, manufacturing policy, working capital cycle, rate of stock return, credit policy, rate of growth, price changes, earnings and dividends. These factors are what makes a company run smoothly if done correctly and makes a business keep its working capital where it should be. Working capital also gives investors an idea of the company’s operational efficiency.
Money that is tied up in inventory or money that customers still owe to the company cannot be used to pay off any of the company’s expenses. This can be done by comparing the working capital from one year to another. This process will also help with forecasting and budgeting. In conclusion, any change in the working capital will have an effect on a business’s cash flows. It is important for a manager to use all the ways that have been spoken about to reduce debt and save on costs. When these are used in combination, it offers the best chances to minimize working capital and increase cash flow.
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