Starting a business is easy, provided you are motivated enough to sustain and keep growing it. But what helps you to keep your business functioning and operating seamlessly? The answer is working capital and its regular management.
In this article, we will be discussing why businesses, be they small or medium-sized, need working capital and its management.
Before we learn why firms need Working Capital Management, let’s first understand a few basic terms that need to be focused on.
Working capital management is the day-to-day management of the firm’s capital for financing regular operational activities.
Talking about working capital, it is specifically the difference between the current assets and the current liabilities of an entity. By current asset or liability, we mean the payable or receivable within an operating cycle.
Therefore, now we can understand that the definition of working capital management is how the firm manages to optimise its receivables and payables in the best possible way to yield the best financial results for the growth of the business. Businesses need working capital management to strike the right balance between how many current assets the firm has and the number of current liabilities it owes.
The fundamental need of a working capital management strategy in any business is to pay short-term liabilities on their due dates conveniently.
Another important reason that businesses need a working capital management system is to generate profits for their businesses. The higher the working capital, the higher will be the profits to ensure the required return on capital employed.
Hence, it is significant to determine a healthy balance between profitability and liquidity while deciding the right strategy for working capital management. While considering the need for working capital management, business owners are required to be careful of over-trading and overcapitalising.
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Why Do Firms Need Effective Management of Working Capital?
The firms need working capital management for carrying out the smooth functioning of the daily operations, but it is a little different from the decisions related to budgeting.
Additionally, instances of inefficiency at any point in management can lead to an impact on working capital management.
Following are the reasons why small businesses need working capital management:
- Working capital management enables Higher Return on Capital
- It helps in the Improvement of Solvency and Credit Profile
- Helps in maintaining Better Liquidity
- It Increases Profitability
- It enables Uninterrupted Production
- Betters the Business Value Appreciation
- Working capital management provides an edge over competitors
- It provides the apt Suitable Financing Terms
Why Working Capital Management is Considered Important?
Working capital management is the basic factor for the seamless running of a business because of the following three major reasons:
- The current assets encompass a majority of the assets.
- The wealth of the shareholder is more closely related to the generation of cash rather than accounting profits.
- The inability to control the working capital, and thus, to control liquidity, is a major reason for the collapse of any business.
How Small Businesses Can Strategise Working Capital Management?
There are various ways by which small businesses can fulfil their need for working capital management. They can implement a wide range of solutions to ensure effective working capital management, both for their suppliers and for business owners. These solutions include:
- Electronic invoicing Methods – providing electronic invoices consequent in speedy delivery of invoices to customers, hence bagging fast payments. This method helps firms to transform purchase orders into invoices automatically.
- Cash flow Predictions – By predicting future cash flows, businesses can prepare for any upcoming cash gaps in advance and ensure better use of any surpluses.
- Supply chain finance – It is also known as reverse factoring – it is a way of offering suppliers advance payment through one or more third-party funders. It further helps the suppliers to then improve their DSO by getting paid early at a minimised cost of funding.
- Dynamic discounting – This also helps the buyers to make early payments to suppliers and enables buyers to secure a risk-free return on their surplus cash.
- Flexible funding – This is another method of working capital management that offers flexible funding that might allow buyers to select between supply chain finance and dynamic discounting models. In simple terms, businesses can adapt to their various working capital requirements while continuing to support their suppliers.
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