Why is Working Capital Management Important?

Top Reasons for Working Capital Management

The accounting strategy of the management, which is designed to monitor and utilize the components of the working capital properly, is known as the working capital management. Working capital management is essential for the proper and smooth working of any business. Working capital management is important in various organizations due to the following reasons –

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  • Improvement in the Credit Profile and Solvency of the CompanySolvency Of The CompanySolvency of a company means its ability to meet the long term financial commitments, continue its operation in the foreseeable future and achieve long term growth. It indicates that the entity will conduct its business with ease.read moreUse of Fixed Assets EfficientlyAbility to Face CrisesExpansion

Let us discuss these in detail one by one.

#1 – Improvement in the Credit Profile and Solvency of the Company

Suppose the company pays off the debts on time while generating revenues. In that case, it ensures that the company’s operating cycleCompany’s Operating CycleThe operating cycle of a company, also known as the cash cycle, is an activity ratio that measures the average time required to convert the company’s inventories into cash.read more is properly funded, which will likely boost the company’s credit score. Whereas if the company is unable to repay its debts on time and still it is running the business with the low operating costs, the creditors will try to get back their funds, which would lead to a decrease in the credit score.

The pre-requisite to long-term solvency is the ability of the company to meet its short-term obligations. Therefore, the adequate management of the working capital will help the business pay all of its short-term obligations on a timely basis, like the salary payment, payment against the purchase of the raw materials, and other such operating expensesOperating ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more.

Conclusion: there is a company, ABC Ltd., which pays all its loans, rent, and vendor bills on time; then this would increase the company’s credit score. This shows how responsible management of the working capital can reward the company in the long run. Once the company has a high credit score, it will also qualify for the business loan at a lower rate, making it easier for the company to procure finances easily and lead the business in good financial standing.

#2 – Use of Fixed Assets Efficiently

Proper management of the working capital and availability of adequate working capital will enable the company to effectively and efficiently use the fixed assetsFixed AssetsFixed assets are assets that are held for the long term and are not expected to be converted into cash in a short period of time. Plant and machinery, land and buildings, furniture, computers, copyright, and vehicles are all examples.read more present. In case of unavailability or lack of working capital, the company’s fixed assets remain idle. In that case, also, the depreciation has to be charged, and the interest on capital borrowed is to be paid on fixed assets, i.e., the company has to incur the fixed expenses on the fixed assets unnecessarily even though it is not using them. So, with the help of working capital management, fixed assets can also be managed and used effectively.

A company ABC ltd manufactures and sells pens in the market. In the last month, it purchased the assets to increase productivity and sales by borrowing the money from the market. The company, however, didn’t look into its working capital position. So even after purchasing the fixed assets, the company cannot utilize its fixed assets properly to increase its production due to a lack of working capital. Also, the company has to incur the depreciation chargesDepreciation ChargesDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more and interest on the borrowed capital unnecessarily even though it is not using the fixed assets.

If the company had managed the working capital properly, this situation would not have arrived. If there is sufficient working capital, fixed assets can be used properly, and production can increase revenue. This is the perfect example of how working capital management can lead to the effective use of the company’s fixed assets.

#3 – Ability to Face Crises

If there is proper management of the working capital, then the business concern will be able to face crises properly during the emergency period like depression. But, generally, the companies don’t have an adequate amount of working capital in case of an emergency, which will negatively affect the business in case an emergency occurs.

There are two companies, ABC Ltd and XYZ Ltd, competing in the town. So suddenly, the situation of depression occurs in the economy. ABC Ltd has an effective mechanism for managing working capital and keeps funds for emergencies. In contrast, XYZ ltd doesn’t properly manage the working capital and doesn’t keep funds for an emergency. So suddenly a situation of depression arises in the economy.

In that case, ABC Ltd will be able to continue its operation as it has proper working capital management, whereas XYZ ltd will have to stop the production as it doesn’t have the working capital. Also, ABC ltd, with adequate working capital, can reap more benefits during this time due to a lack of working capital management by its competitor.

#4 – Expansion

If any company plans to expand its business, that would require additional capital. However, if there is adequate working capital management, that could lead to the successful implementation of the expansion program.

ABC Ltd. doesn’t have adequate working capital management and plans to expand its business. So, in that case, it cannot successfully implement the expansion because it has to arrange the facilities required for the expansion, which currently it is not having because of the inadequate WCM.

Conclusion

Its main motive includes the maintenance of sufficient cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more in the business every time to meet the short-term funds required for the operations and pay off the short-term obligations. They need to vary among different industries and similar companies as well. It helps ensure that the company’s operations are performed financially efficiently. Suppose any company doesn’t have enough working capital to cover its obligations. This financial insolvency can lead to legal troubles for the company and even the liquidation of the company’s assets.

They help not only in covering the financial obligations of the company but at the same time also help the company in boosting its earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more. Thus, all business enterprises need to ensure adequate management of the working capital in their organization.

This has been a guide to Working Capital Management Importance. Here we discuss its meaning along with examples and detailed explanations. You may also learn more about Accounting from the following articles –

  • Days Working CapitalCalculate Working Capital Turnover RatioCalculate Changes in Net Working CapitalFormula of Net Working Capital