Working capital is a business’s money or assets to run the day-to-day business. This is found by taking the current liabilities and current assets and subtracting them. A good strategy for managing working capital will help a business make the most money and stay liquid. Cash, trade receivables, and inventories are the main things that make up current assets. Under current liabilities, you can find trade payables, bank overdrafts, and short-term loans.
Working Capital Management
An analysis of the effects of the COVID-19 outbreak done by the world-famous auditing firm PwC shows that businesses must focus on liquidity rather than short-term profits in times of crisis. So, a company needs a good plan for managing its working capital to stay in business.
Thriving and Surviving
Profitability and cash flow determine whether a business is doing well or not. For example, businesses that make a lot of money and have a lot of cash flow do well, while businesses that make less money but still have a lot of cash flow survive. The key to this is how well the working capital is managed.
Profitable businesses sometimes have problems because they don’t have enough money to meet their short-term obligations. Especially now, when the COVID-19 pandemic has hurt the global economy, it’s smart to be disciplined about strategic investments.
What is a Strategy for Working Capital Management?
There are three main ways to manage working capital: conservative, hedging, and aggressive. How well these three methods work depends on how risky and profitable they are.
The conservative strategy is based on long-term financial instruments to get money for fixed assets, permanent working capital, and part of the temporary working capital. Long-term finances are low risk because they are not affected by changes in interest rates. “No pain, no gain” means that if you don’t go through pain, you won’t get anything out of it.
Hedging is when long-term funding sources pay for long-term assets and a part of permanent working capital. Here, the short-term working capital will be paid for by short-term loans and trade credit. Long-term funding will be used for fixed assets like machinery and infrastructure. This strategy is profitable and has a moderate amount of risk.
In the aggressive strategy, fixed assets and part of a permanent working capital are paid for with long-term funds. Short-term funding sources will pay for the remaining permanent and temporary working capital. This is risky, but it could be more profitable because short-term funds have a low cost of borrowing. At the same time, market trends and changes in interest rates could affect these things.
How to make a good plan for managing working capital
Working capital management is heavily affected by things like interest rates, how much the market wants a business’s products, the economy, the exchange rate, the seasons, and market trends. Because of how these things are connected, managing working capital is a complicated task requiring much attention.
For example, the pandemic has caused the global economy to go into recession because trade and travel bans have been lifted and borders have been closed. Since trading has stopped, market demand, interest rates, and currency exchange rates have all taken a hit.
Because of this, companies are now trying to get back on their feet in uncharted territory. Let’s look at the steps that need to be taken to make a working capital management strategy that gets results.
Assess Existing and Future Funding Needs
The first step in making a good plan for managing your working capital is to look at your long-term and short-term funding needs. Short-term funding needs include rent, utilities, payroll, and supplier payments.
Long-term funding needs include upgrading machinery and equipment, buying real estate for the company, and other ways to grow the business. When making the organization’s working capital strategy, it is important to analyze one’s current and future funding needs. A look at the short-term and long-term needs for money.
Think of possible situations and how your business might handle them.
We live in a volatile, complex, uncertain, and unclear world. Because of this, it’s important to keep an eye on market trends and the state of the industry and economy. Do a SWOT analysis to discover growth possibilities and dangers you might face. Once you know the opportunities and threats, you can do a scenario and shock analysis to see how well the organization would handle a situation like that.
Consider your sources of working capital funding.
Check your cash accounts, trade receivables, and stock to ensure you have enough cash to cover the organization’s working capital needs. Diversify when you need to. You could take out a short-term loan to compensate for the lack of cash or make short-term investments to make more money. It is also smart for a business to keep its cash and investment opportunities in at least two different banks to get credit even when the economy is bad.
Review the accounts payable and receivable.
Introduce ways to pay for your products or services online or electronically to avoid delays in trade receivables. Making it easier for customers to pay will boost demand and customer satisfaction. Before giving a customer credit, you should think about the 5Cs.
This will make it much less likely that they will become bad debtors. As for account payables, set up a process or schedule for paying suppliers in cash or by check, which will need approval. This will eliminate ad hoc payments and make the payment process easier.
What works best for a business depends on how it plans operations and uses its assets. But every business needs to learn how to manage its working capital to stay in business.