The Importance of Working Capital Management to the Survival of Business Organisations free essay sample

CHAPTER ONE 1. 1 INTRODUCTION Working Capital has been defined as the net asset of a business, that is, the excess of current assets over current liabilities. It is the resources required to conduct the daily of core activities of any business setup small businesses, medium businesses or large scale enterprises. Any business which desire to perpetually remain in business must ensure a healthy level of its working capital by maintaining a sound relationship between the current assets and current liabilities as required by various factors as defined by the market and its own policies. The finance manager has the responsibilities of carrying out careful analysis of every activity having financial implication on the company in order to check and control any under or over utilization of the organization’s resources which may have any shortcoming effects on the realization of the corporate goal. Every business needs finance for two purposes: * Long term financing which is required to provide facilities upon which the business will carry out its operations; and * Short term financing which the business needs for the recurring purchase of raw materials, payment of wages and salaries and other day-to-day expenses. It is referred to as revolving or circulating or working capital. It is simply the difference between the current assets and the current liabilities as defined above. As a business owner, you must constantly be alert to changes in working capital and their implications; otherwise, you may miss some warning signs that can lead to business failure. Performances of businesses in terms of profits made at a particular period, financial health and strength in terms of advantages over their competitors at any point in time are areas to which working capital contributions cannot be looked down upon. Hence, it is important for managers to ensure relentless efforts towards keeping a sound working capital level in order to optimally achieve organizational goals. An effective and efficient management of the working capital resources is a necessity for all forms business and sizes for continuous operation and favorable return on investment. This is known as working capital management. The manager takes several items which constitute working capital into consideration such as inventories, account receivables and account payables. In fact, these components of working capital are so important that analysts look to the combined health of all of these areas of operation as an indicator of an individual companys level of efficiency. It is a short term capital required to finance a firm on a day-to-day basis. It is a key measure of business liquidity. The more working capital a firm has, the less risk there is of the firm not being able to pay its creditors when the bills become due. Conversely the less working capital a firm has, the greater the risk of the firm not being able to pay its creditors when the bills are due. Working capital is an operational necessity (Fung, Hebb ; Rogers 2001). A firm needs to invest in short-term current assets such as stocks and also needs debtors to allow it to perform its day-to-day operations. This investment in current assets is for the short term, as raw materials will be bought, converted into finished product, and sold to customers who ultimately will pay. For many businesses this cycle will be completed within a short timeframe, and will be repeated many times over during the year. For others, this cycle may become considerably extended. The investment in current assets requires to be financed and a primary source of this financing is the firm’s current liabilities, particularly the credit received from suppliers. In relation to shareholder value, the firm’s investment in working capital should produce cash returns that add to the market value of the firm and thus to the wealth of its shareholders. However, excessive investment in working capital will depress returns, by increasing the opportunity costs of having funds unnecessarily tied up in current assets (Mcmenamin 1999). Alternatively, insufficient investment in working capital increases the firm’s risk of financial distress or insolvency by not having sufficient funds available to pay creditors when the bills become due. A constant preoccupation of the financial manager will be  trying to establish in working capital management the risk-return trade-off which maximizes the market value of the firm. It is worth re-emphasizing that while working capital management accentuates short-term financial decisions and policies, these will, however, be framed in the context of the firm’s overall corporate strategy, with the aim of realizing its strategic objectives and the primary goal of maximizing shareholder value (Nanda ; Narayanan 2004). Effective working capital management involves financial decision-making, planning and control activities related to each of the above three elements of working capital. Sufficient working capital is needed, not only to be able to pay bills on time   but also to be able to carry sufficient stocks and also to allow debtors a period of credit to pay what they owe. Working capital is thus the kind of capital required to finance a firm on a day-to-day basis. Recall that working capital is also a key measure of business liquidity. The more working capital a firm has, the less risk there is of the firm not being able to pay its creditors. Conversely the less working capital a firm has, the greater the risk of not being able to pay creditors when payment becomes due. Having an adequate level of working capital is therefore vitally important for the survival of any business. Bearing in mind that the overall goal of the firm is the maximization of shareholder wealth, for the financial manager the objective of working capital management is to help achieve this goal (Comiskey ; Mulford 2000). To this end there are two key tasks involved in the management of working capital. One is the key task of achieving a balance in investment: not to over- or under-invest funds in working capital. Excessive investment in working capital is a wasteful and unproductive use of resources: insufficient investment in working capital risks costly disruptions to operations and possible insolvency (Studart 1995). The key task for the financial manager is to determine the level of working capital which balances risk and return and maximizes shareholder wealth. The other key task is managing the rate of asset turnover, which is an indicator of how efficiently a company utilizes its assets: the higher the rate of an asset’s turnover the less money needs to be invested in the asset. The level of investment in working capital needs to be sufficient to permit the firm to operate smoothly and efficiently. To invest more than this level represents money unnecessarily tied up in idle current assets, money that could be used more profitably elsewhere in the business. Over-investment in working capital, that is, having a level of working capital which exceeds operational requirements, is a wasteful and inefficient use of funds. On the other hand, under-investment in working capital, that is having a level of working capital which is below operational requirements, can hamper and rustrate daily operations (Barsky ; Jablonsky 2001). Managing the working capital is important to make sure that the firm is able to continue operating with enough finances to pay debts and spend on some future expenses. Managing the working capital can be done by the use of cash management, inventory management, debtors’ management and the concept of short term financing. Managing the w orking capital can be exemplified by some companies mostly manufacturing. They use the concept of short term financing to manage their working capital. Such companies can make further use of working capital management by making sure that they properly manage their debtors and their liabilities effectively. Companies need to make sure that they will have enough sources of finances and budgets by making sure that all their debtors will give their dues. Managing the debts involve reminding the debtors their responsibility regularly. The most important component of working capital is cash, far the most important asset of any business, particularly a small business. Without it, the business will fail. So it is of paramount importance for you as the business owner to control all cash transactions. It is helpful for us, as a business owner, to think of working capital in terms of five components: 1. Cash and equivalents- This most liquid form of working capital requires constant supervision. A good cash budgeting and forecasting system provides answers to key questions such as: Is the cash level adequate to meet current expenses as they come due? What is the timing relationship between cash inflow and outflow? When will peak cash needs occur? When and how much bank borrowing will be needed to meet any cash shortfalls? When will repayment be expected and will the cash flow cover it? 2. Accounts receivable- Many businesses extend credit to their customers. If you do, is the amount of accounts receivable reasonable relative to sales? How rapidly are receivables being collected? Which customers are slow to pay and what should be done about them? 3. Inventory- Inventory is often as much as 50 percent of a firm’s current assets, so naturally it requires continual scrutiny. Is the inventory level reasonable compared with sales and the nature of your business? What’s the rate of inventory turnover compared with other companies in your type of business? 4. Accounts payable- Financing by suppliers is common in small business; it is one of the major sources of funds for entrepreneurs. Is the amount of money owed suppliers reasonable relative to what you purchase? What is your firm’s payment policy doing to enhance or detract from your credit rating? 5. Accrued expenses and taxes payable- These are obligations of your company at any given time and represent a future outflow of cash.