Determinants of Working Capital

Working capital is simply the money a business requires to complete daily operations. Working capital is the difference between current assets and current liabilities. Furthermore, sound working capital management is required for businesses because if current assets exceed liabilities, companies must take loans, which no company wants to do. 

So, before getting into this situation, a company manages its working capital. Effective working capital management allows a company to reduce its reliance on external borrowing and expand its operations. It also enables fund merging, acquisitions and investments in R&D. In this article, we will learn about working capital management and its goals.

Discover Unacademy UPSC Offline Centres in the following locations 

• Mukherjee Nagar IAS Coaching in Delhi
• Best IAS Coaching in Karol Bagh
• Best UPSC Coaching in Prayagraj

What is Working Capital?

Working capital, or networking capital, is the difference between a company’s current assets like cash and unpaid bills of customers and its current accountabilities, like cash and debts.

Working capital assesses a company’s liquidity, short term financial health and operational efficiency. If an account receivable does not surpass its current accountabilities, the company may struggle to grow or repay creditors and even declare bankruptcy.

Check out the complete UPSC Syllabus

What is Working Capital Management? 

Working capital management is a business tool that assists businesses in making effective use of current assets while maintaining sufficient cash flow for short-term goals and commitments. By effectively managing working capital, companies can free up funds that otherwise would have been stuck on their financial statements. As a result, they may decrease their reliance on external lending, grow their operations, merge funds or invest in research and development.

Working capital is condemnatory to the health of any business, but effectively managing it is a balancing act. Companies must have good cash to cover both anticipated and unknown expenses while also using the financing available. This is accomplished through efficient accounts payable, receipts, inventory and cash management.

What are the Working Capital Determinants?

Working capital is determined by a number of factors, all of which affect how much money is put into current assets and liabilities. Working capital may consume a significant portion of an organisation’s available funds. Thus managers pay close attention to these variables. 

As a result, managers are always looking for methods to reduce the amount of working capital. 

The following is a list of factors that influence a company’s working capital.

• Policy on Credit: If a corporation extends easy credit terms to its consumers, it invests in long-term accounts receivable
• Tightening the lending rules can lower this investment, but some consumers may be turned away
• Rate of Change: Fast-expanding companies tend to increase their investments in accounts receivable and inventories
• Working capital will continue to rise until the company’s revenues are large, making it impossible to pay for these receivables and inventories
• A company’s working capital needs will decrease when its revenue declines; this frees up cash
• Terms of Payment for Payables: A corporation can save money on working capital by receiving a free loan from its suppliers by negotiating longer payment terms
• Working capital measures how much money a company has available to spend
• Flowchart of the Manufacturing Process: Inventories tend to balloon when companies overestimate their production requirements and underestimate actual demand
• A just-in-time system, on the other hand, only manufactures things when they are ordered, reducing the need for inventory
• Seasonality: An inventory asset may be necessary if a firm sells most of its products in one year
• Outsourcing labour or paying more for items to be manufactured at the last minute might lessen this investment in inventory

Visit to know more about UPSC Exam Pattern

Objectives of Working Capital Management

Working capital is an essential business tool because it symbolises the availability of capital to make a payment, cover unforeseen expenses and keep business running as usual. However, working capital management is not that simple, and a working capital management programme may have multiple objectives, such as:

• Taking Care of Your Accounts Receivables

A corporation should provide customers with the appropriate level of flexibility or commercial credit while also ensuring that the appropriate quantities of cash come into the company through operations. Customers’ financial health, industry rules, and the actual policies of rivals will all be considered while determining the credit conditions offered by a firm to them. 

• Meeting Obligations

Working capital management must always ensure that the company has enough cash flow to meet its short-term commitments. It can be accomplished by collecting payments from customers sooner or extending provider payment terms. Unexpected expenses can also be regarded as obligations, so they must be factored into the working capital management strategy.

• Capital Performance Optimisation

Another goal of working capital management is to enhance capital usage either by lowering capital costs or increasing capital returns. Lowering capital costs can be accomplished by taking back locked up capital to reduce borrowing. In contrast, increasing capital returns entails ensuring that the RoI of spare capital is more than the average price of financing it.

Also see: UPSC Question Paper

Working capital Management Solutions

Companies can use a range of approaches to support efficient working capital management for themselves and their suppliers. 

These are some examples:

• Supply Chain Finance

Supply chain finance, also recognised as reverse factoring, is a method for buyers to offer suppliers early payment through one or more third-party financial backers. Providers can enhance their day’s sales outstanding (DSO) by paying people quicker at a low financing cost, while purchasers can retain their cash flow by paying on time.

• Funding Flexibility

Working capital suppliers that provide flexible funding may enable buyers to transition seamlessly among supply chain finance, allowing businesses to adapt to changing working capital requirements while funding their suppliers.

• Forecasting Cash Flow

Businesses can plan for any forthcoming cash gaps and create good use of any surpluses by predicting future cash flows, such as receivables and payables. The better informed your management of working capital decisions are, the more precisely you can anticipate your future cash flows.

• Dynamic Discounting 

Another solution that purchasers can use to continue providing early payments to vendors is dynamic discounting – but without an external funder because the buyer funds the programme through early payment discounts. This, like supply chain finance, allows vendors to reduce their DSO. Furthermore, it enables buyers to earn an appealing risk-free return on their surplus money.

Conclusion

Working capital represents the availability of funds to make a payment, cover unexpected expenses and keep business operations running. As a result, managing working capital is essential. By effectively managing working capital, a company can reduce its reliance on external lending, expand its operations, fund mergers and invest in research and development. Effective working capital management enables a company to reduce its reliance on external borrowing, expand its operations, merge funds and acquisitions and invest in research and development.