Working capital management is often adopted as a strategic managerial accounting function. The main objective of working capital management is to maintain efficient levels of the two components of working capital – current assets and current liabilities – concerning each other. By efficiently managing its working capital the firm would be able to ensure that it always has sufficient liquid cash to meet its obligations on current liabilities which are short-term in nature (Investopedia). The working capital management also includes the meeting of current operating expenses from a well-maintained cash flow.
Brealey et al (2005) define the working capital to include assets and liabilities which are short-term in nature. They are also known as current assets and liabilities. The working capital management in any organization includes controlling and monitoring the book debts, inventory, and cash and bank balances of the organization. Efficient working capital management enables a company to compete effectively in the market as it can reduce its cost of producing the goods or services. The working capital management also provides the company the liquidity to meet its short-term obligations without difficulty. Any organization to achieve its financial goals should ensure that there is proper working capital management is in place. The essence of successful working capital management is to ensure that the current liability obligations of the company are met without delay. The adoption of a working capital policy and a system of cash budgeting will enable the company to optimize the utility of its working capital. This will lead the company to reach a stage where it would be easier for the company to meet its current obligations without much difficulty.
Implementing an efficient working capital management system enables a company to augment its earnings by reducing the cost of working capital locked up in undesirable items of current items like excess inventory. There are two main components of working capital management. They are; (i) management of individual components of working capital and (ii) ratio analysis
Management of Different Components of Working Capital
Generally, decisions relating to the quantum of working capital and short-term financing of the firm’s requirements are referred to as working capital management. Thus by definition, working capital management entails only short-term managerial decisions covering the next one-year period. Hence working capital decisions are always reversible. Therefore working capital management decisions do not involve complex processes like capital investment decisions. Such decisions are normally based on the cash flows into the firm and/or profitability.
Accounts receivable accounts payable and inventory are the major components of working capital that a company has to manage effectively. Cash is another important component of working capital that plays a crucial role in working capital management. The function of managing the working capital of a company can be discharged effectively by developing and introducing a cash budgeting system that takes care of the cash inflows and outflows of the organization.
One way of measuring the cash flow of the firm is the cash conversion cycle. The cash conversion cycle is calculated based on the net number of days from the outflow of cash for purchasing of raw material till the time the payment is received from the customer of the firm. The cash conversion cycle as a working capital management tool informs the management of the inter-relatedness of its decisions concerning the working capital elements like inventory, accounts receivable, accounts payable, and cash. Cash conversion cycle days exactly correspond to the total time the financial resources of the company are blocked in the conversion process. During this period cash is not available for other activities. Therefore the aim of the management always is to have a lower conversion cycle.
The working capital management function involves dealing with day-to-day cash management, collection of accounts receivables, dealing with bad debts, and the repayment of short-term loans. Thus the working capital management policy of any organization is to estimate and monitor the extent of each of the current assets account of the company and also to decide in advance how these accounts can be funded.
Inventory management aims to identify the level of inventory that allows for an uninterrupted supply of raw materials and components for production. At the same time, there should be a reduction in the amount invested in raw materials.
Ratio Analysis
The Working Capital ratios indicate how well the company can manage its working capital. “The asset management ratios are also known as working capital ratios or the efficiency ratios. The aim is to measure how effectively the firm is managing its assets.” (Net Tom) The calculation and analysis of few key working capital ratios like inventory turnover ratio, average debtors, and average accounts payable would enable the management to identify the areas where more attention is required. The average debtor indicates how many days the company takes to collect its outstanding debtors in proportion to the total sales. Average Accounts Payable implies how many days on average it takes for a company to pay off its creditors. Inventory turnover shows how many times the company can roll over its inventory. Ratio analysis enables the firm to have effective inventory management, cash management, accounts receivable, and accounts payable management.
References
Brealey R. A., Myers S. C. & Allen F. (2005). Principles of Corporate Finance 8th Ed. New York: The McGraw-Hill Companies.
Investopedia ‘Working Capital Management’. Web.
Net Tom ‘Session 14: Calculation of Ratio Analysis’. Web.