Working capital management (Essay Sample)

Working Capital Management Author Name InstitutionIntroduction Working capital management is an essential part in financial management of a company. Working capital is the current assets net of current liabilities. Current assets refer to accounts receivables, inventory and cash and equivalent. Working capital management, therefore, is applying financing and investment decisions to the management of the current assets. It can also be referred to as managerial strategy of accounting. The strategy focuses on maintaining an efficient level of current assets, working capital and current liabilities. Working capital management ensures that the company has enough cash flows. Efficient working capital management ensures that the company is able to meet its short term debt obligations as well as its operating expenses (Pass & Pike, 1984). A company’s value can be created by an optimal working capital management. In order to attain this, companies should be able to control the trade-off accurately between profitability and liquidity. Profitability is determined in terms of the size of earnings after taxes. Liquidity refers to the ability of keeping sales coming, pay bills and retaining of customers. Working capital management is what maintains a company. It is, therefore, essential for every manager to make it flow and generate profits using the cash flows. Objectives of working capital management For working capital management to be effective it requires clear objectives that need to be addressed. There are two key objectives. One is to increase profitability of a company and ensuring enough liquidity. Profitability of a company is related to shareholders wealth maximization goal. Investments should be made if an appropriate return is achieved for current assets. Liquidity is needed for continuation of business. For example, a company may hold more cash for transaction or operational needs than what is needed. The cash may be for speculative or precautionary measures. There are factors that affect the company’s level of working capital. These factors include; nature or type of business. Manufacturing based companies have a higher level of working capital compared to service based companies. The volume of sale is also another factor. The higher the sales the higher the amount of working capital is required. Seasonality affects the working capital in that the peak seasons demand higher working capital. Also, a longer operating and cash cycle increases the working capital level (Gitman, 2008). Working capital approach/policies Because working capital management is essential in a business, firms need to formulate policies. These policies should be concerned with the working capital components. Firms should have these policies to manage cash, inventory, short-term investments and trade receivables. The policies will help managers make decisions which are in the interest of a firm. The decisions may include investments that are needed in current assets. The policies set should also consider the nature of business. The policies are different to different business because each business requires different capital requirements. For example, a manufacturing company needs to invest heavily on components and spare parts. The customers might owe the business large amounts of money. A food retail shop will need large inventories for resale but have few trade receivables. Therefore, a manufacturing company policy should emphasize on management of receivables. The food retail shop should limit their credit facilities (Afza & Nazil, 2008). Some policies include matching or hedging, conservative and aggressive policy. The matching policy matches assets with liabilities to maturity. Here, a firm uses long term sources in financing permanent current assets and fixed assets. It also uses short term sources to finance temporary current assets. Conservative policy is when a firm prefers to have more cash at hand. The policy also prefers investing in short term securities as well as holding higher inventory levels. The policy has lower risk of inventory or financial problems, but it reduces profitability (Gitman, 2008). Aggressive policy means that a firm prefers to operate with low level of cash, inventory and trade receivables. The policy increases the profitability since less cash is used in current assets. There are also some risks in this policy such as running out of inventory and cash shortages. Optimization of working capital Companies have their focus on increasing working capital management to improve their financial metrics. Some of the reasons why they want to optimize working capital include; the current management is not effective to meet customers need. They experience shortage of working capital to support business expansion and operational requirements. Companies face challenges in managing working capital due to pressure of growth. These pressures may include market segmentation or new product acquisition (Pass & Pike, 1984). Working capital management can be optimized by supply chain management strategies and financial strategies. The supply chain management is essential because it optimizes the working capital. Firms may improve the forecast accuracy and also find other routes to optimize the inventory. Companies also need to make the right decisions on how much inventory to stock. The lead time also need to reduce to optimize working capital. Companies should also strive to improve their collaboration with the supplies. Collaborating with supplies usually has a direct impact on working capital requirements. The most essential financial strategi...