Working capital management forms an integral part of any business. Picture it as the lifeblood of your business, the oxygen that keeps it breathing and thriving. Yet, despite its importance, many SMEs find themselves struggling with the complexities of working capital.
In recent years, the number of SMEs in India has surged to nearly 6.3 million. However, only 2.5 million of them have accessed credit through formal sources. These figures highlight the considerable challenges faced by small businesses when it comes to securing funding, often stemming from limited resources and a lack of collaborative opportunities.
Whether you’re a seasoned entrepreneur looking to fine-tune your financial strategies or a newcomer navigating the SME landscape, this blog article will help you understand the world of working capital management.
So, let’s dive in and discover the art and science of working capital management, a skill set that could very well be the cornerstone of your SME’s success story.
What is working capital management?
Working capital management is a financial strategy that involves overseeing and optimising a company’s short-term assets and liabilities to ensure its day-to-day operational efficiency and financial stability. It’s all about managing the liquidity and financial resources needed to run a business smoothly.
SMEs must balance their assets and liabilities to run their operations smoothly. Every step a business takes to manage its current assets and liabilities is part of working capital management.
The end target of all functions of working capital management is to maintain enough liquidity in the business for its uninterrupted operations – such needs are often associated with the supply of labour, raw materials, wage payments, and other overhead expenses.
Unlocking working capital management dynamics: the factors at play
There are two factors that decide how much cash a company needs: stuff from inside the company (we call it “endogenous”), and things from outside the company (we call it “exogenous”). These things are like puzzle pieces that fit together to figure out how much money a company should keep.
Endogenous factors: These factors originate from within the company itself and encompass elements such as its size, organisational structure, and strategic initiatives. For instance, a company operating on a modest scale with a limited workforce generally demands a smaller working capital reserve. Conversely, an enterprise engaged in large-scale production must maintain a substantial working capital to procure labor and raw materials efficiently.
Exogenous Factors: In contrast, exogenous factors are external to the company and extend beyond its immediate control. These encompass variables such as the availability of banking services, prevailing interest rates, the competitive landscape, and the industry in which the company operates. These external forces can significantly impact a company’s working capital needs.
How to calculate working capital?
The formula to calculate working capital is as follows:
Working capital = Current Assets – Current Liabilities
Current assets: These are assets that are expected to be converted into cash or used up within one year or the normal operating cycle of the business, whichever is longer. Examples of current assets include:
- Cash: The money a company has in its bank accounts.
- Accounts receivable: Money owed to the company by its customers for goods or services sold on credit.
- Inventory: Goods held for sale, such as products in a retail store or raw materials in a manufacturing facility.
- Prepaid expenses: Payments made in advance for services or expenses that will be incurred in the future, such as insurance premiums.
Current liabilities: These are debts and obligations that are expected to be settled within one year or the normal operating cycle of the business. Examples of current liabilities include:
- Accounts payable: Money owed by the company to its suppliers for goods or services purchased on credit.
- Short-term loans: Loans that need to be repaid within one year.
- Accrued liabilities: Unpaid expenses that have been incurred but not yet paid, such as wages and utilities.
- Bank overdraft: The excessive funds you withdraw from your bank account above the available balance.
Let’s assume a company has a total current assets of Rs. 40 lakhs and current liabilities of Rs. 15 lakhs. In this case, a company’s working capital shall be Rs. 25 lakhs. Hence, it is the cash available with the company that it can utilise to fund its operations only after setting aside money for all its current liabilities.
Also read: Top 3 Strategies and Approaches of Working Capital Management
Importance of working capital management for SMEs
Working capital management is especially critical for SMEs due to their unique financial challenges and resource constraints. Here are several reasons highlighting the importance of working capital management for SMEs:
- Cash flow management: SMEs often have limited access to external financing, making effective cash flow management essential. Proper working capital management ensures that SMEs have enough liquidity to cover day-to-day expenses, reducing the risk of insolvency.
- Operational efficiency: Efficient working capital management allows SMEs to optimise their operations. For instance, it helps in managing inventory levels to prevent overstocking or stock outs, which can be costly for small businesses with limited storage space and capital.
- Supplier relationships: Timely payments to suppliers are crucial for maintaining good relationships, securing favourable credit terms, and negotiating discounts. Effective working capital management enables SMEs to negotiate better terms and build trust with suppliers.
- Customer relations: SMEs need to collect accounts receivable promptly to maintain healthy cash flows. This requires diligent monitoring and collection efforts. Managing accounts receivable effectively helps in building strong customer relationships and ensures timely revenue.
- Minimising financing costs: SMEs often rely on short-term loans or lines of credit to cover working capital needs. By optimising working capital, SMEs can reduce their reliance on expensive financing options, minimising interest expenses.
- Flexibility and adaptability: SMEs may face rapid changes in demand or unexpected expenses. A well-managed working capital position provides the flexibility to adapt to these changes without disrupting operations.
- Investment opportunities: Effective working capital management allows SMEs to accumulate surplus cash that can be invested in growth opportunities or used as a financial cushion during economic downturns.
- Risk mitigation: SMEs are more vulnerable to economic uncertainties, market fluctuations, and unexpected events. Adequate working capital acts as a buffer against financial shocks and reduces the risk of business failure.
- Creditworthiness: Banks and other lenders assess an SME’s working capital position when evaluating loan applications. A healthy working capital position can enhance an SME’s creditworthiness, making it easier to secure financing when needed.
- Sustainability: SMEs often operate on thin profit margins. Effective working capital management helps ensure the long-term sustainability and profitability of the business by preventing cash flow crises that could lead to insolvency.
- Strategic planning: Working capital management provides valuable insights for strategic decision-making. It helps SMEs identify areas for improvement, allocate resources efficiently, and plan for growth or diversification.
Working capital management decision
Decisions related to management of working capital are critical for SMEs. They can impact your company’s financial health and ability to seize growth opportunities. By understanding and effectively managing your working capital, you can position your SME for long-term success.
Frequently Asked Questions
Q1. What are the different types of working capital?
Ans. The different types of working capital include gross working capital, net working capital, operating working capital, and non-cash working capital.
Q2. Where can I check the current assets and current liabilities of my business?
Ans. The current assets and liabilities are a part of your business’s balance sheet. By referring to the respective heads, you can see a breakdown of your current assets and current liabilities.
Q3. What are the different types of working capital management?
Ans. The different types of working capital management include liquidity management, account receivables management, inventory management, accounts payable management and short-term debt management.
Did you know?
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