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