Techniques For Managing Working Capital Effectively

Why Do Businesses Fail?

Recently, a study was conducted of all the sick businesses in the world to know the reason behind general business failure and their inability to stay in the game. This study found four generic  causes of business downfall:

  1. Technological Obsolescence
  2. Marketing Inefficiencies
  3. Labour Problems
  4. Financial Mismanagement.

The surprising part of the above study was that from the following 4 causes, 95% of the business downfall was caused due to financial mismanagement. This means that only 5% of business failure was due to either technology obsolescence, marketing inefficiencies or labor problems. Hence, setting up your business well financially and managing your finances is of utmost importance

Reasons For Financial Mismanagement

The reason behind financial mismanagement is that people in the position of power to make decisions such as the procurement team, marketing team, sales team, etc consider themselves as ‘Non-Finance people’ and wrongly believe that it is the accounting team or the finance department’s responsibility to managing finance.

The truth is that everyone in the organization is responsible for maintaining the financial records as everyone’s action has a financial implication and has an effect directly or indirectly on the Profit and Loss account. For example if the sales team sells on the wrong terms like credit period it affects the working capital position, similarly, if the production team does a wrong production scheduling it has a financial implication. Thus, it can be said that financial management is the ability to understand the financial implications of one’s actions on the company as a whole.     

What’s Working Capital And Its Importance?

Working capital is defined as the funds which are used in the day to day business operations of a company. They usually are termed as current assets (inventory, cash, and account receivables) and current liabilities (account payables and short term loans). The efficient management of working capital is important for both,  the profitability and the financial health of the company. Hence, it is important to invest your money in such a way that the assets of the company will generate an inflow of funds before the liabilities demand an outflow.

Techniques For Managing Working Capital Effectively

There are a number of techniques for managing working capital more effectively and efficiently which are as follows:

  • Pay suppliers on time or deal with suppliers offering better credit terms.:  In the case of paying suppliers on time, though it may seem strange, it actually leads to getting better deals and negotiating favorable terms and leads to better working relationships.
  • Control expenses carefully:   This can be done by setting budgets and closely monitoring them at regular intervals.
  • Stock management:  It is important to find the right balance of stock maintenance in a way that excess cash flow is not locked up in stock due to overbuying and at the same time it is crucial to have enough stock in hand to be able to convert immediate orders. A quarterly or bi-yearly check on stocks can help in getting the balance right.
  • Emergency loans can be a short term solution: It can come handy at times when there is a dire need of cash flow to complete an immediate or unplanned order.
  • Loans against the assets of the company:  This is usually termed as ‘ Asset-based financing’ wherein you can borrow against the value of the premises, plant, machinery, and equipment of the company.   
  • Invoice factoring: Invoice factoring is done when a finance company or factor takes responsibility of your accounts receivables which means that you can enjoy faster payments and avoid the stress of bad debts at a nominal factoring cost. The Government has recently introduced a facility called TReDS especially for MSME’s.
  • Invoice discounting:  Another alternative to the above, where you want to deal with your debtors and do not want any third party involved in Invoice discounting where you can get your invoice discounted and acquire immediate finance.

 

Working Capital Cycle And Rotations Per Year

It is important to take stock of your working capital cycles wherein you are in a position to calculate the number of rotations of working capital that you manage in a year. The more the rotations the better the productivity and profitability.

For example, in the case of a manufacturing unit, cash is used to purchase inventory.

This inventory going through manufacturing processes and gets converted into finished products.

On selling this finished product, it gets converted into debtors and receivables.

On the due date, these debtors get converted into cash again.  

This cycle of cash to cash is called the working capital cycle.

It is important to calculate the period that the above cycle takes. If it is assumed that it takes say 8 months, then it can be said that the working capital is able to obtain 1.5 rotations in a year. The length of this period can be worked upon and shortened which will lead to an increase in the number of rotations per year.

Working Capital Ratios – Current Ratios and Quick Ratios:-

It is ideal to have a current ratio of 2:1 i.e the current assets should be twice of the current liabilities.

On the other hand, quick ratios are similar to current ratios, with the only exception of inventory as part of the current assets, the reason being that inventory takes a slightly more considerable amount of time to convert into cash than other current assets. The ideal quick ratio should be 1:1.

If the current ratio falls below 2:1, it may not be an immediate cause for alarm, however, if the quick ratio falls below 1:1 it poses a very serious matter and if corrective measures are not taken urgently, it can lead to financial insolvency.

If you require any guidance with regards to managing your cash flow, do reach out to your Savage & Palmer Accounts Manager

About the Author

Post by:  CA Taha Kaiser

Taha Kaiser is working as an Accounts Manager in Savage & Palmer for almost a year and is handling an extremely large portfolio of clients covering the fashion industry, food industry, manufacturing, and retail sector and the Broadcasting and Designing sector. He offers advice and support to handle working capital problems and also looks to identify possible underlying problems to ensure a positive future for any business.    

 

 

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