Working capital is one of the basic metrics used to evaluate a company’s financial health. A high level of working capital indicates significant liquidity.
A. Importance of Adequate Working Capital
A business firm must maintain an adequate level of working capital in order to run its business smoothly. It is worthy to note that both excessive and inadequate working capital positions are harmful. Working capital is just like the heart of business. If it becomes weak, the business can hardly prosper and survive. No business can run successfully without an adequate amount of working capital.
If a company’s current assets do not exceed its current liabilities, then it may run into trouble paying back creditors in the short term. The worst-case scenario is bankruptcy.
A declining working capital ratio over a longer time period could also be a red flag that warrants further analysis. For example, it could be that the company’s sales volumes are decreasing and, as a result, its accounts receivables number continues to get smaller and smaller.
The main advantages or importance of working capital are as follows:
1. Strengthen Solvency
With adequate working capital firms have enough cash in hand and can operate smoothly without any financial problems. Financial activities like purchase of raw materials, payment of salaries and wages and overheads can be made on time without any delays. Adequate working capital helps in maintaining solvency of the business by providing uninterrupted flow of production.
2. Enhance Goodwill
Prompt payment of all dues i.e. salaries, wages and other payments on procurement of raw materials enables a firm to earn goodwill. Goodwill is enhanced because all current liabilities and operating expenses are paid on time. It also helps earn firm new business as people know they would be paid on time and are always ready to do business with you.
3. Easy Obtaining Loan
Financial institutions look at working capital of an organization as one of the important parameters in determining the firms capability in repaying loan. A firm having adequate working capital, high solvency and good credit rating can arrange loans from banks and financial institutions in easy and favorable terms.
4. Regular Supply of Raw Material
As me discussed earlier prompt payment ensures regular supply of raw materials from suppliers. Suppliers are satisfied by the payment on time. It ensures regular supply of raw materials and continuous production.
5. Smooth Business Operation
Working capital is really a life blood of any business organization which maintains the firm in well condition. Any day to day financial requirement can be met without any shortage of fund. All expenses and current liabilities are paid on time.
B. Danger of inadequate working capital
When working capital is inadequate, a firm faces the following problems.
Fixed Assets cannot efficiently and effectively be utilized on account of lack of sufficient working capital. Low liquidity position may lead to liquidation of firm. When a firm is unable to meets its debts at maturity, there is an unsound position. Credit worthiness of the firm may be damaged because of lack of liquidity. Thus it will lose its reputation. There by, a firm may not be able to get credit facilities. It may not be able to take advantages of cash discount.
Concept of working capital
One of the most important areas of finance to monitor is your company’s working capital, which is the difference between current assets and current liabilities. As a small business owner, you must constantly be alert to changes in working capital and their implications; otherwise, you may miss some warning signs that can lead to business failure. The most important component of working capital is cash, far the most important asset of any business, particularly a small business. Without it, the business will fail. So it is of paramount importance for you as the business owner to control all cash transactions.
It is helpful for us, as a business owner, to think of working capital in terms of five components:
1. Cash and equivalents
This most liquid form of working capital requires constant supervision. A good cash budgeting and forecasting system provides answers to key questions such as: Is the cash level adequate to meet current expenses as they come due? What is the timing relationship between cash inflow and outflow? When will peak cash needs occur? When and how much bank borrowing will be needed to meet any cash shortfalls? When will repayment be expected and will the cash flow cover it?
2. Accounts receivable
Many businesses extend credit to their customers. If you do, is the amount of accounts receivable reasonable relative to sales? How rapidly are receivables being collected? Which customers are slow to pay and what should be done about them?
Inventory is often as much as 50 percent of a firm’s current assets, so naturally it requires continual scrutiny. Is the inventory level reasonable compared with sales and the nature of your business? What’s the rate of inventory turnover compared with other companies in your type of business?
4. Accounts payable
Financing by suppliers is common in small business; it is one of the major sources of funds for entrepreneurs. Is the amount of money owed suppliers reasonable relative to what you purchase? What is your firm’s payment policy doing to enhance or detract from your credit rating?
5. Accrued expenses and taxes payable
These are obligations of your company at any given time and represent a future outflow of cash.