Working capital management is an important component of management of corporate finance; since it directly influences firm’s profitability as well as liquidity in everyday activities. In any business organization, it is obvious that there must be sufficient working capital to run day to day operation. Therefore, to operate the business activities smoothly, working capital of firm’s must be sufficient. Then, the concern of working capital management is setting sufficient (optimal level) of working capital and managing short term assets and liabilities of firms within a specified period of time, usually one year. It is obvious that, the importance of efficient working capital management is unquestionable to all business activities. Because, business capability relies on its ability to effectively use (manage) receivables, inventories and payables.
If there are excessive stock, debtors and cash and very few creditors, there will be an over investment in current asset. The inefficiency of managing working capital will cause this excessive working capital resulting in lower returns in working capital employed. and long-term funds will be unnecessarily tied up when they could be invested to earn profit. This situation is known as over-capitalization of working capital.
Under-capitalization is a situation where a company does not have funds sufficient to run the normal operation smoothly. This may happen, due to inefficient working capital or diversion of working capital funds to finance capital items. If the company faces the situation of under-capitalization, then it will face difficulty in meeting current obligation, procurement of raw material, meeting day-to-day running expense etc. The result will ultimately be reduced profitability, and reduced turnover. The finance manager must take immediate and proper step to overcome the situation by making arrangements for sufficient working capital. For this purpose he should prepare the realistic cash flow and fund flow statement of the company.
Some of the symptoms of inefficient working capital management are:
- Excessive carriage of inventory over the normal levels required for business will result in more balance in trade creditors account. More creditors balance will cause strain on the management in management of cash.
- Working capital problem will arise when there is a show down in collection of debtors.
- Sometimes capital goods will be purchased from the funds available for working capital. This will result in the working capital and its impact on the operation of the company.
- Unplanned production schedule will cause excessive stock of finished goods or failure in meeting dispatch schedule. More funds kept in the form of cash will not generate any profit for the business.
- Inefficiency in using potential trade credit require more funds for financing working capital.
- Over-trading will cause shortage of working capital and its ultimate effect is on the operation of the company.
- Dependence in short term source of finance for financing permanent working capital causes less profitability and will increase strain on management in managing working capital.
- Inefficiency in cash management will cause embezzlement of cash.
Therefore, working capital should neither too high nor too low. Excessive working capital indicates an accumulation of idle current assets (resources) which don’t contribute in generating income (profit) for the firm during the operating period. On the other side, inadequate working capital harms the credit worthiness and the day to day activities of firms and this may lead to insolvency (bankruptcy).