Why a good working capital management is so important?
To really understand the importance of a good capital working management, we first have to know what working capital and working capital management are. Working capital is the term given to the difference between current assets which can include sticks of rawmaterials, work-in-progress and finished goods, debtors, short-term investments and cash; and current liabilities which can include trade creditors, overdrafts and short-term loans. The purpose of working capital is to finance needs of companies because there is a lag between the dates of cash inflows and outflows. Actually, a company generally has to advance expenses to put orders into production,orders that will be paid, at best, when customers will receive orders. That is why it is so important to have sufficient resources to allow the continuity of business activity.
Working capital management is a decision-making strategy in order to secure the development of a company, to increase the profitability of a company and to ensure that it has sufficient liquidity to meet short-termobligations as they fall due and so continue in business. To help take these decisions, companies have to implement clear policies for different components of working capital like the management stack, debtors, cash and short-term investments. But many working capital decisions are straightforward since they tend to be repetitive. So, companies have to create some rules to help the management make somedecisions easily. For example, each time a customer seeks to buy goods on credit, a decision will be needed as to whether to grant credit at all and if so how much. So, if there are rules which explain how take these decisions, employees can make them, they don’t have to ask their boss all the time, so this is a gain of time and of money. But, companies have to be careful; they have to often reviewrules because companies’ environment frequently changes.
Companies have also to decide if they want have an aggressive policy which means that it operate with lower levels of stock, debtors and cash for a given level of activity or sales, it will increase profitability but also increase risk; a conservative policy which is more flexible, with a larger cash balance, perhaps even investing inshort-term securities, offering more generous credit terms to customers and holding higher level of stock, with a lower risk but a lower profitability too, or a moderate policy which is between the aggressive and conservative approaches.
Working capital management include choosing the level of working capital, as seen previously, but also, planning the budget which could be beneficial to thecompany. In this aim the choice of how financing working capital management by making the trade-off between risk and return is important. Companies, in the policy decisions, have to choose the level of investment in current assets; if they want invest in fixed assets which are long-term assets from which a company expects to derive benefit over several periods like factory building and productionmachinery, in permanent current assets which represent the core level of investment needed to sustain normal levels of trading activity, such as investment in stocks and investment in the average level of a company’s debtors or in fluctuating current asserts which are variations in the level of currents assets arising from normal business activity.
With an effective working capital management,companies have the ability to assess in advance the calls that will be made on the various elements of working capital this allow to managers to ensure that the tanks are always adequately full.
Usually, businesses, with working capital, should seek to minimise the level of each type of current asset that they hold and to maximise the benefits of cheap short-term finance; but at the extreme there are...