Working capital is one of the important measurements of the financial position. The words of H. G. Guttmann clearly explain the importance of working capital. “Working Capital is the life-blood and nerve center of the business.”
What is Working Capital?
A firm’s profitability is determined in part by the way its working capital is managed. The object of working capital management is to manage the firm’s current assets and liabilities in such a way that a satisfactory level of working capital is maintained.
If the firm cannot maintain a satisfactory level of working capital, it is likely to become insolvent and may even be forced into bankruptcy.
10 Importance of Working Capital
Thus, the need for working capital to run day-to-day business activities smoothly can’t be overemphasized. Specific importance is discussed below;
- To Avail of Cash Discounts
- It creates a Feeling of Security and Confidence.
- ‘Must’ for Maintaining Solvency and Continuing Production
- Sound Goodwill and Debt Capacity
- Easy Loans from the Banks
- Distribution of Dividend
- The Exploitation of Good Opportunity
- Meeting Unseen Contingency
- High confidence
- Increased Production Efficiency
To Avail of Cash Discounts
If a proper cash balance is maintained, the business can avail advantage of cash discounts by paying cash for the purchase of raw materials and merchandise. It will result in reducing the cost of production.
It creates a Feeling of Security and Confidence.
The proprietor, officials, or management of concern are quite carefree if they have proper working capital arrangements because they need not worry about the payment of business expenditures or creditors.
Adequate working capital creates a sense of security, confidence, and loyalty, not only throughout the business itself but also among its customers, creditors, and business associates.
‘Must’ for Maintaining Solvency and Continuing Production
To maintain the solvency of the business, a sufficient amount t of the fund must be available to make all the payments on time as and when they are due.
Without ample working capital, production will suffer, particularly in the era of cut-throat competition, and a business can never flourish in the absence of adequate working capital.
Sound Goodwill and Debt Capacity
It is common to the experience of all prudent businessmen that promptness of payment in business creates goodwill and increases the debt of the capacity of the business.
A firm can raise funds from the market, purchase goods on credit, borrow short-term funds from the bank, etc if the investor and borrowers are confident that they will get their due interest and payment of principal in time.
Easy Loans from the Banks
An adequate working capital, i.e., excess of current assets over current liabilities, helps the company to borrow unsecured loans from the bank because the excess provides good security to the unsecured loans; banks favor granting seasonal loans if the business has a good credit standing and trade reputation.
Distribution of Dividend
If a company is short of working capital, it cannot distribute the good dividend to its shareholders despite sufficient profits. Profits are to be retained in the business to make up for the deficiency of working capital.
On the other contrary, if working capital is sufficient, an ample dividend can be declared and distributed. It increases the market value of shares.
The Exploitation of Good Opportunity
In case the adequacy of capital is a concern, good opportunities can be exploited, e.g., the company may make off-season purchases resulting in substantial savings, or it can fetch big supply orders resulting in good profits.
Meeting Unseen Contingency
Depression shoots the demand for working capital because sock piling of finished goods becomes necessary. Certain other unseen contingencies, e.g., financial crisis due to heavy losses, business oscillations, etc., can easily be overcome if the company maintains adequate working capital.
companies need to prepare and account for unseen contingencies.
High confidence
Providing adequate working capital improves the morale of the executive because they have an environment of certainty, security, and confidence, which is a great psychological factor in improving the overall efficiency of the business and of the person who is at hell of fairs in the company.
Increased Production Efficiency
A continuous supply of raw materials, research programs, innovations, and technical development and expansion program can successfully be carried out if adequate working capital is maintained in the business.
It will increase production efficiency, #which will, in turn, increase the efficiency and morale of the employees and lower costs, and create an image among the community.
How Working Capital Affected by Sales, Technology, and Production Policy, Inflation
The working capital needs of a firm are determined and influenced by various factors.
A wide variety of considerations may affect the quantum of working capital required, and these considerations may vary from time to time. The working capital needed at one point in time may not be good enough for some other situation.
The determination of working capital requirements is a continuous process and must be undertaken regularly in light of the changing situations.
How Working Capital Affected by Sales?
Sales may be affected or change due to business cycle fluctuations and seasonal operations of any business.
With the increase or decrease of sales, investment in accounts receivables increases or decreases, as well as the investment in raw materials and work in progress also increases or decreases. Let’s address the issues in the following two points;
How Working Capital Affected by Business cycle fluctuations?
Different phases of the business cycle, boom, recession, and recovery, also affect the working capital requirement. In the case of boom conditions, inflationary pressure appears, and business activities expand.
As a result, the overall need for cash, inventories, etc., increases, resulting in more and more funds blocked in these current assets.
In the case of the recession period, however, there is usually a dullness in business activities, and there will be an opposite effect on the level of working capital requirement. There will be a fall in inventories and cash requirements etc.
How Working Capital Affected by Seasonal operations?
If a firm is operating in goods and services having seasonal fluctuations in demand, then the working capital requirement will also fluctuate with every change.
In a cold drink factory, the demand will certainly be higher during the summer season and therefore, more working capital is required to maintain higher production in the form of larger inventories and bigger receivables.
On the other hand, if the operations are smooth and even throughout the year, then the working capital requirement will be constant and will not be affected by seasonal factors.
How Working Capital Affected by Technology & Production Policy?
In the case of manufacturing concerns, different types of production processes are performed. One unit of raw material introduced in the production schedule may take a long period before it is available as finished goods for sale.
Funds are blocked not only in raw materials but also in labor expenses and overheads at every stage of production. The operating cycle is usually a long one, and sales are generally made on credit terms.
So, in the case of manufacturing concerns, there is a requirement for substantial working capital.
How Working Capital Affected by Inflation?
The price level changes require the firm to keep more amount of working capital to go hand in hand with the price changes, which normally affect the firm’s liquidity position.
During periods of inflation, the firm is required to anticipate price level changes, which drastically affect the working capital position of the firm. Thus, the working capital requirement of a firm is determined by a host of factors.
Every consideration is to be weighted relative to determine the working capital requirement.
Further, the determination of working capital requirement is not once a while exercise. Rather a continuous review must be made to assess the working capital requirement in the changing situation.
There are various reasons which may require a review of the working capital requirement, e.g., change in credit policy, change in sales volume, etc.
