Explain the Importance And Objectives Of Managing Working Capital ( Part 1)

September 9th, 2006 Comments off
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Introduction:

Basically, there are two types of capital need which comprises the following:

  • Fixed capital to invest in fixed assets like building, plant and equipment which tends not to vary in the short term. Tends only to be volatile when when major investment decisions are made for example when assets are purchased or sold and

  • Working capital, on the other hand, is much more fluid and fluctuates with the level of business. The working capital cycle links directly with the cash operating cycle. Comprises short term net assets: stock, debtors, and cash, less creditors.

Working Capital Management:

Is the management of all aspects of both current assets and current liabilities, so as to minimize the risk of insolvency while maximizing return on assets.

The primary objective of working capital management is to ensure that sufficient cash is available to:

  • meet day-to-day cash flow needs;
  • pay wages and salaries when they fall due;
  • pay creditors to ensure continued supplies of goods and services;
  • pay government taxation and providers of capital, dividends; and
  • ensure the long term survival of the business entity.

It is critical to understand that Profit is not Cash. A company can be very profitable but it can collapse simply because it has insufficient cash/liquidity to pay its relevant bill (as stated above).

Always remember that any company liabilities are settled with cash and not by profit.

Importance in Optimizing Working Capital Management:

Poor working capital management can lead to:

Characteristics of over-capitalisation are excessive stocks, debtors, and cash, low return on investment with long term funds tied up in non-earning short term assets.

Over-trading leads to escalating debtors and creditors, and if unchecked, ultimately to cash starvation.

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Financial Accounting

 
 

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