What is working capital - what should an entrepreneur know about it?
The company's financial liquidity depends to a large extent on the level and structure of working capital. What is working capital? How to properly manage it? We advise you in the article below.
Working capital - definition
Working capital is the value we get by deducting current liabilities in relation to:
suppliers - due to unpaid bills for completed deliveries,
employees - due to remuneration,
banks - due to short-term loans,
the state financing system - in respect of taxes, social security contributions, fees and other current liabilities
on the value of the company's current assets.
The gross value of this type of capital is represented by the company's current assets (current assets), which are used in current operations. On the other hand, net worth is defined as the difference between fixed capital and fixed assets or as the difference between current assets and short-term liabilities.
Net working capital is also that part of the firm's fixed capital that finances current assets but does not finance fixed assets.
The company's working capital may include only those assets that have been in the company for less than 12 months.
For example, the net working capital (also known as working capital) may include: inventories (goods, finished products, materials, semi-finished products and products in progress, advance payments for deliveries), short-term receivables (taxes, subsidies, customs, insurance, other, for supplies and services, pending court proceedings, other) short-term investments (cash and other cash assets, other short-term investments).
Why is working capital important?
Working capital helps the company maintain financial liquidity. It can be especially useful when customers are behind with payments or when the trader has problems selling his goods. The presence of working capital means that you can continue running your business without taking loans. In addition, it is a protection against the consequences of financial loss, which may turn out to be very dangerous for the company.
If the company has positive working capital, it means that it has a certain solvency margin, thanks to which it will be able to pay its liabilities, even in the event of a worse financial situation.
It is important to maintain an appropriate level of net working capital in order to maintain the appropriate proportions between the company's growth rate, its sales and the level of current assets.
To increase the level of the company's working capital:
To reduce the level of working capital:
The company's demand for working capital - how to calculate?
To calculate the company's working capital requirements, the net cash balance must be subtracted from the working capital value.
The amount of working capital required depends on the market situation of a given company.
Greater demand may arise if:
payment terms will be extended by the company's customers,
the terms of payment of liabilities will be shortened,
sales of goods will increase.
Working capital management - ingredients and strategies
When dealing with the management of the company's working capital, first of all, one should take care of the balance between its financial liquidity and the profitability of the business. And so, in the case of managing working capital, one must particularly focus on:
cash - so as to keep such an amount that will allow to settle liabilities on time;
inventories - so that their level allows for smooth production and is sufficient for the production of new goods; at this point, one should also remember to ensure the lowest possible storage, transport and order costs;
receivables - by regulating the company's credit policy; in this case, it is worth persuading customers to buy, but at the same time control the impact of extended payment terms so that it is as low as possible;
short-term debt - by selecting such a structure of short-term sources of financing that will allow for the lowest possible debt servicing costs.
The strategies that can be used to manage a company's working capital are combinations of current asset management and liability management. There are four such concepts.
It is a tactic of managing current assets and liabilities, in which the aim is to maintain a low balance of current assets in relation to current liabilities. Its characteristic feature is the possibility of obtaining high profits, but with a high level of risk.The result of applying this strategy is a reduction in financial liquidity and an increase in the company's profitability.
By using this concept in relation to assets, the aim is to limit liquid assets (below the level of 50% of assets). The basis for the efficiency of activities undertaken as part of this strategy is the high profitability of fixed assets, the use of which would not be conducive to a large freezing of current assets. Maintaining a low share of cash in assets contributes to obtaining a higher level of return on capital.
In contrast, in the case of an aggressive liability strategy, the goal is to maximize periodic financial resources at the expense of fixed capital. This is related to the maintenance of short-term liabilities at the level of more than 50% of the value of liabilities. The use of such a tactic is associated with the risk of loss of financial liquidity and an increase in the current capital due to the increase in the marginal cost of capital. The latter activity is caused by the necessity to achieve an appropriate rate of return on capital, which may compensate for the risk of losing financial liquidity.
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This type of management of current assets and liabilities is based on maintaining a high level of current assets, while maintaining a low value of current liabilities. Typical of him is the chance to make a small profit with a small level of risk. The effect of applying a conservative strategy is obtaining high financial liquidity, but it is associated with a decrease in the company's profitability.
In the case of assets, this strategy is to hold a large amount (over 50%) of the most liquid assets - short term securities and cash. The remaining surplus is used to liquidate unexpected liabilities (but only in the case of not having the appropriate amount from operating receipts). The persistence of such a surplus means less possible profit. Moreover, additional costs may arise from inventory held in the event of unexpected demand.
On the other hand, the use of a conservative strategy in the case of liabilities is aimed at minimizing short-term liabilities in the company's debt structure (level below 50% of the value of liabilities). It consists in minimizing the short-term loan or abandoning the long-term loan in favor of equity. Unfortunately, such a tactic makes it necessary to achieve a high rate of return, which would be enough to cover the loss caused by the involvement of expensive equity capital. However, there is also a positive side - the risk of insolvency is reduced.
Among the tactics described above, there is a moderate strategy. It may assume a conservative asset strategy and an aggressive liability strategy - or vice versa: an aggressive asset strategy and a conservative liability strategy. This affects the balanced nature and safety of this tactic - it requires average costs of external financing, gives minimal financial liquidity and moderate effects of financial leverage. Thus, as a result, it minimizes the risk and enables incurring rational costs of using current assets.
The choice of a specific financial strategy for managing a company's working capital depends on many factors. First of all, the current economic situation of the country, which shapes the demand and supply in a given period, is important. In addition, the profile of the company's activity is important - one model will not work in all cases. Managers also need to decide on a rate of return on capital that suits them best and the risks involved.
For companies that are just starting out or experiencing a financial crisis, it may be a good idea to use a conservative strategy (ensuring low returns with low risk). On the other hand, companies with staff familiar with the market, customers and suppliers can use an aggressive strategy (assuming high profit and high risk).