The capital involved in any business enterprise can broadly be classified into two categories—working capital and fixed capital. Actually, every business needs funds for two purposes—for its establishment and to carry out its day- to- day operations. Long term funds are required to create production facilities through purchases of fixed assets such as plant, machinery, land, building, furniture etc. Investments in these assets represent that part of the firm’s capital which is blocked on a permanent or fixed basis and is called fixed capital. Funds are also needed for short-term purposes: for the purchase of raw materials, payments of wages and other day-to-day expenses etc. These funds are known as working capital.
Importance of working capital management
For every business enterprise, it is very crucial to maintain its working capital at an optimum level; otherwise the business will not be able to meet its short-term liabilities, which is lethal for its existence. But at the same time, if a business holds working capital in excess, it would leave less capital for the business to invest in long-term revenue-generating activities. So it should neither be in excess nor too little. To maintain the working capital at an optimum level, the finance manager of an organization should be an expert in working capital management.
In most simple terms, balancing between the current assets and the current liabilities of the company in order to keep the liquidity of the company at an optimum level is known as working capital management.
Working capital = current assets – current liabilities
Gross working capital = sum of all the current assets
Efficient working capital management includes-
1. Preparing the working capital policy of the firm
2. Day-to-day management of the cash, receivables and inventory.
3. Arrangement of short-term finances
High investment in working capital causes-
1. Idling of funds that lead to no returns to the firm.
2. High level of inventory increases the carrying cost, supervision cost and risk of spoilage.
3. As we know that liquidity is inversely proportional to profitability, so, higher liquidity means lesser profitability.
Low investments in working capital causes-
1. Illiquidity in the organization is the greatest threat for the good will and the long-term survival of the organization.
2. Lack of working capital will cause deficiency of inventory which will further effect the production.
3. Under-deficient WC situation. If an emergency (machine breakage, plant failure, stock out etc) occurs then the firm will have to opt for external borrowings, which is always risky and expensive.
Factors affecting the working capital decision
There are various factors that contribute in making a decision about working capital of the firm. Some of these factors are-
1. Nature of the business, for example, manufacturing organizations require heavy working capital as compared to service-based industries.
2. Seasonality of business, for example, air-conditioner manufacturing companies require more working capital in summers as compared to winters.
3. Level of the operations.
4. Market conditions, for example, during a recession, demand will be less so the working capital required will also be less.
5. Production policy.
6. Supply conditions.
7. Dividend policy.
8. Credit policy.
9. Length of the operating cycle.