Effective working capital management: Essential tips

27 Jun 2022 | Finance

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Hooshang Bakht

Brego Business was started with a mission to make entrepreneurship easy. Our goal is to help business owners grow and scale without having to deal with the day-to-day stress of running a business. We specialize in providing services that help business owners grow their businesses, including Digital Marketing, search engine marketing (SEM), social media marketing (SMM), LinkedIn marketing, video production, accounts receivable (AR), accounts payable (AP), internal audit, VCFO, and recruitment. We have helped more than 500 brands grow their businesses. We work closely with clients to understand their unique needs and develop customized strategies that deliver measurable results.

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Techniques For Managing Working Capital Effectively

Why Do Businesses Fail?

Recently, a study was conducted of all the sick businesses in the world to know the reason behind general business failure and their inability to stay in the game. This study found four generic  causes of business downfall:

  1. Technological Obsolescence
  2. Marketing Inefficiencies
  3. Labour Problems
  4. Financial Mismanagement.

The surprising part of the above study was that from the following 4 causes, 95% of the business downfall was caused due to financial mismanagement. This means that only 5% of business failure was due to either technology obsolescence, marketing inefficiencies or labor problems. Hence, setting up your business well financially and managing your finances is of utmost importance

Reasons For Financial Mismanagement

The reason behind financial mismanagement is that people in the position of power to make decisions such as the procurement team, marketing team, sales team, etc consider themselves as ‘Non-Finance people’ and wrongly believe that it is the accounting team or the finance department’s responsibility to managing finance.

The truth is that everyone in the organization is responsible for maintaining the financial records as everyone’s action has a financial implication and has an effect directly or indirectly on the Profit and Loss account. For example if the sales team sells on the wrong terms like credit period it affects the working capital position, similarly, if the production team does a wrong production scheduling it has a financial implication. Thus, it can be said that financial management is the ability to understand the financial implications of one’s actions on the company as a whole.     

What’s Working Capital And Its Importance?

Accounting working capital refers to the funds that are required for a company’s day-to-day business operations. It includes current assets such as inventory, cash, and account receivables, as well as current liabilities such as account payables and short-term loans. Efficient management of accounting working capital is crucial for the profitability and financial health of the company. To ensure that the assets of the company generate an inflow of funds before the liabilities demand an outflow, it is essential to invest money wisely. By optimizing accounting working capital, companies can improve their cash flow, reduce financial risk, and enhance their ability to seize growth opportunities.

Techniques For Managing Working Capital Effectively

There are a number of techniques for managing working capital more effectively and efficiently which are as follows:

  • Pay suppliers on time or deal with suppliers offering better credit terms.:  In the case of paying suppliers on time, though it may seem strange, it actually leads to getting better deals and negotiating favorable terms and leads to better working relationships.
  • Control expenses carefully:   This can be done by setting budgets and closely monitoring them at regular intervals.
  • Stock management:  It is important to find the right balance of stock maintenance in a way that excess cash flow is not locked up in stock due to overbuying and at the same time it is crucial to have enough stock in hand to be able to convert immediate orders. A quarterly or bi-yearly check on stocks can help in getting the balance right.
  • Emergency loans can be a short term solution: It can come handy at times when there is a dire need of cash flow to complete an immediate or unplanned order.
  • Loans against the assets of the company:  This is usually termed as ‘ Asset-based financing’ wherein you can borrow against the value of the premises, plant, machinery, and equipment of the company.
  • Invoice factoring: Invoice factoring is done when a finance company or factor takes responsibility of your accounts receivables which means that you can enjoy faster payments and avoid the stress of bad debts at a nominal factoring cost. The Government has recently introduced a facility called TReDS especially for MSME’s.
  • Invoice discounting:  Another alternative to the above, where you want to deal with your debtors and do not want any third party involved in Invoice discounting where you can get your invoice discounted and acquire immediate finance.

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Working Capital Cycle And Rotations Per Year

Short term working capital management is essential for businesses to maintain cash flow and liquidity. It is important to keep track of the working capital cycles, which help in calculating the number of rotations of short term working capital managed in a year. The more the rotations, the better the productivity and profitability of the business. For instance, in a manufacturing unit, short term working capital is utilized to purchase inventory. This inventory goes through various manufacturing processes and is eventually converted into finished products. Effective management of short term working capital helps in reducing the cash conversion cycle and ensures that the business has sufficient cash to meet its short term financial obligations. By optimizing short term working capital, businesses can improve their financial health and enhance their ability to take advantage of growth opportunities

On selling this finished product, it gets converted into debtors and receivables.

On the due date, these debtors get converted into cash again.

This cycle of cash to cash is called the working capital cycle.

It is important to calculate the period that the above cycle takes. If it is assumed that it takes say 8 months, then it can be said that the working capital is able to obtain 1.5 rotations in a year. The length of this period can be worked upon and shortened which will lead to an increase in the number of rotations per year.

Working Capital Ratios – Current Ratios and Quick Ratios:-

Effective working capital management is crucial for businesses to maintain a healthy financial position. The current ratio, which is the ratio of current assets to current liabilities, is an important measure of working capital management. Ideally, the current ratio should be 2:1, indicating that the current assets are twice the current liabilities. Another important ratio for working capital management is the quick ratio, which is similar to the current ratio, except that inventory is not considered as part of current assets. This is because inventory takes a slightly longer time to convert into cash than other current assets. The ideal quick ratio should be 1:1.

If the current ratio falls below 2:1, it may not be an immediate cause for alarm, but it does indicate a need for closer monitoring of working capital management. However, if the quick ratio falls below 1:1, it poses a very serious matter for the financial health of the business. Urgent corrective measures are needed to avoid the risk of financial insolvency. Effective working capital management is crucial for businesses to maintain a healthy financial position and to ensure that they have sufficient liquidity to meet their short-term obligations.

If you require any guidance with regards to managing your cash flow, do reach out to your Brego Business Accounts Manager

About the Author

Post by:  CA Taha Kaiser


Taha Kaiser is working as an Accounts Manager in Brego Business for almost a year and is handling an extremely large portfolio of clients covering the fashion industry, food industry, manufacturing, and retail sector and the Broadcasting and Designing sector. He offers advice and support to handle working capital problems and also looks to identify possible underlying problems to ensure a positive future for any business.

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Frequently asked questions

1)What is working capital management?

Working capital management is the process of managing a company's short-term assets and liabilities to ensure it has enough cash flow to meet its day-to-day expenses.

2)Why is working capital management important for businesses?

Working capital management is important for businesses because it helps them maintain liquidity and financial stability. It ensures that a company has enough cash flow to cover its expenses and invest in growth opportunities.

3)What are the key components of working capital management?

The key components of working capital management are cash management, inventory management, accounts receivable management, and accounts payable management.

4)What is short-term working capital?

Short-term working capital refers to the capital required by a business to cover its day-to-day operating expenses. This includes expenses such as payroll, rent, and utilities.

5)How can a company improve its working capital management?

A company can improve its working capital management by implementing effective cash flow forecasting, optimizing inventory levels, and managing accounts receivable and accounts payable efficiently.

6)What is the role of accounting in working capital management?

Accounting plays a crucial role in working capital management by providing accurate and timely financial information that can help businesses make informed decisions about their cash flow.

7)What are the risks of poor working capital management?

Poor working capital management can lead to cash flow problems, which can result in missed payments, late fees, and damage to a company's credit rating. It can also lead to missed growth opportunities and reduced profitability.

8)How can a company determine its optimal working capital level?

A company can determine its optimal working capital level by analyzing its historical cash flow patterns, identifying trends and seasonality, and considering its business goals and growth plans.

9)How can working capital management impact a company's profitability?

Effective working capital management can help a company improve its profitability by reducing costs associated with missed payments, late fees, and inventory holding costs.

10)What are some common working capital ratios used by businesses?

Common working capital ratios used by businesses include the current ratio, the quick ratio, and the cash conversion cycle. These ratios can help businesses analyze their liquidity and working capital efficiency.