Table of Contents
- 1 Importance of Working Capital
Working capital is part of the total capital employed by a company and is often defined as the difference between short-term liabilities and short-term assets. Practically speaking, it is the cash required to run the daily, weekly and monthly operations of a business. Working capital management is, therefore, the process of managing the short-term assets and liabilities so that a firm has sufficient liquidity to run its operations smoothly.
The components and determinants of working capital are summarized in the table below.
The efficiency of working capital management can be measured through a variety of methods and ratios. Financial analysts typically compare the working capital cycle and other working capital ratios against industry benchmarks or a company`s peers. The most commonly used ratios and measures are the current ratio, days of sales outstanding, days of inventory outstanding and days of payables outstanding.
Liquidity is often tight in small businesses due to the scale of their operations and investment in working capital is a drag on liquidity. The majority of small businesses are not able to fund the operating cycle with account payables so they have to rely on the cash generated internally or, in some cases, a cash injection from their owner. An efficient working capital management will, therefore, allow a business to run efficiently and potentially free up some cash which could be used to pay down debt or invest in a profitable project.
Importance of Working Capital
Working capital is a vital part of a business and can provide the following advantages to a business:
Higher Return on Capital
Firms with lower working capital will post a higher return on capital so shareholders will benefit from a higher return for every dollar invested in the business.
Improved Credit Profile and Solvency
The ability to meet short-term obligations is a pre-requisite to long-term solvency and often a good indication of counterparty’s credit risk. Adequate working capital management will allow a business to pay on time its short-term obligations which could include raw materials, salaries, and other operating expenses.
According to a research conducted by Tauringana and Adjapong Afrifa, the management of account payables and receivables is an important driver of small businesses’ profitability.
A large amount of cash can be tied up in working capital, so a company managing it efficiently could benefit from additional liquidity and be less dependent on external financing. This is especially important for smaller businesses as they typically have a limited access to external funding sources. Also, small businesses often pay their bills in cash from earnings so an efficient working capital management will allow a business to better allocate its resources and improve its cash management.
Increased Business Value
Firms with more efficient working capital management will generate more free cash flows which will result in a higher business valuation and enterprise value.
Favorable Financing Conditions
A firm with a good relationship with its trade partners and paying its suppliers on time will benefit from favorable financing terms such as discount payments from its suppliers and banking partners.
A firm paying its suppliers on time will also benefit from a regular flow of raw materials, ensuring that the production remains uninterrupted and clients receive their goods on time.
Ability to Face Shocks and Peak Demand
An efficient working capital management will help a firm to survive through a crisis or ramp up production in case of an unexpectedly large order.
Firms with an efficient supply chain will often be able to sell their products at a discount versus similar firms with inefficient sourcing.
Working Capital Management, ManikaGarg, Educreation Publishing, 2015.
The Relative Importance of Working Capital Management and its Components to SMEs Profitability, By Tauringana and AdjapongAfrifa, Journal of Small Business and Enterprise Development, Vol. 20, No. 3, 2013, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2341848.