Updated on: Jan 19th, 2022
3 min read
Working capital is vital for every business as it’s used to fund the day-to-day operations, meet short-term liabilities, and plan growth. Now, let’s decode working capital and understand why working capital management is important for the growth of an enterprise.
Working capital is the difference between a company’s current assets such as cash, inventories and accounts receivables and its current liabilities such as accounts payables and short-term loans. Working capital, also known as networking capital, measures a company’s liquidity and financial health.
Working capital can be positive or negative. Positive working capital refers to a situation where an enterprise’s current assets are more than its current liabilities. Negative working capital is when its current liabilities exceed its existing assets. It is not good for any business to have negative working capital as that means that the business does not have liquid assets to pay off its short-term liabilities. At the same time, it is not favourable for a business to maintain a high net working capital. This indicates that the business has excess inventory or is not wisely investing its cash.
Every enterprise should efficiently manage its working capital to ensure it has the liquidity to fund short-term expenses and debt, and all of its excess cash is utilised effectively. Inventory is typically purchased from suppliers on credit in any organisation, goods are manufactured, and the final product is typically sold on credit. The cash collected from customers is then used later to pay off suppliers and to meet other expenses. This creates the individual components of working capital, such as inventories, cash, accounts receivables, accounts payables, etc.
Working capital management helps maintain the smooth flow of operations between these components and can help to improve an enterprise’s earnings and profitability. Working capital management includes inventory management, cash management, accounts receivables management, and accounts payables management. The objectives of working capital management include ensuring a smooth operating cycle, minimising the cost of capital in regard to working capital, and maximising return on current investments.
This article is the first in the series ‘Understanding the facets of working capital management’.
Read next – Common challenges faced by enterprises in working capital management.