Impact of Working Capital on Firm’s Profitability

By Samuel

For a firm to operate, the entrepreneur is expected to combine economic factors such as land, labor and capital. As a matter of fact to purchase the other economic factors money is obtained either from investment or from a loan which can still be looked as capital. This initial finance is needed for the firm to exist before it starts making profits. When all these economic factors are set in place and operating, the firm will need another capital for the day to day running of the firm’s activities and such a capital can be regarded as the working capital. The growth of the firm depends on how effective they operate their working capital in order to make profit. The profit can be reinvested, permitting the company to expand its horizons.

The money needed to purchase current assets in a firm is the working capital in that firm and it is cash that has been converted to inventories. At the end of the day the finished product is distributed and then sold to obtain cash from which profit is derived.

Working capital

The working capital is the measure of the how healthy a company is in terms of its finances. It is used to evaluate the efficiency of the firm. Working capital can as well be illustrated mathematically as the difference between current assets and current liabilities.

Using the working capital ratio one can tell if the firm is capable of paying or covering its short term debts using the short term assets of the company. The ratio of the current assets to that of the current liabilities give the working capital ratio and it is important because it can help the company evaluate their capacity of refunding their depts. The amount in hand required by the company to repay its debt is considered as the working capital requirement. The profitability of a firm is linked to its working capital in the sense that if the working capital ratio is less than 1, this shows that the firm is operating at a deficit. In order words it operates on a negative working capital and in this case the firm does not operate on a profit. On the other hand, a working capital ratio greater than 2 tells the firm that they are making enough profit and has accumulated excess assets.

Developing the components of working capital

The components that make up working capital are the current assets and the current liabilities. Among the things that make up current assets are sundry debtors, pre-payment, the balance in the bank and the remaining cash at hand, inventories or stocks (raw material, finished goods, consumer’s stores and the work in progress). If the current assets in a firm grow larger it is an indication of profit making from the firm. On the other hand current liabilities will refer to other financial expenses that seek to reduce the working capital in the firm like payable bills, dividends, tax payments to the government and bank overdraft.

Why do firms need working capital?

The live and running of the firm is based on working capital. The working capital is used for the purchase of raw material, running of day to day activities and the delivery of the end products to the various customers of the firm. For a company to meet up with the demands of its products in the market so that they can maintain their customers for the profitability of the company, there is need for continues supply of raw material, processing and distribution. Similarly, wages of workers are paid out of the working capital; as a result the workers turn to be efficient and execute their duties appropriately to keep the customers satisfied and make more profits to the company.

Another use of working capital is to purchase and efficiently use fix assets for example land. When a firm needs to expand production or move into another kind of products, they obviously need land and appropriate infrastructure for the running of the business. The working capital makes such purchases possible and by so doing the company spread risk and makes more profit. The image of a firm and its reputation counts in the world of business. This is to say that a firm with an effective working capital is able to pay the loans it collected and keep a good record to the eyes of the public. This increases the purchase of the products and increases profitability.

Types of working capital

There are many types of working capital. Among these are:

        I.            Gross working capital                                                                                 

The gross working capital is the capital that is used in the purchase of the various components that make up current assets.

      II.            Net-working capital

In an event where the working capital is computed and the result shows that the current assets are more than the current liabilities, then the result is termed the net working capital. This shows the company how much they need as current assets to meet up with their current liabilities.

    III.            Positive working capital

This refers to a surplus when we talk of net working capital that is current assets more than current liability.

    IV.            Negative working capital

When a firm operates under negative working capital, it shows that the current liabilities are more than current assets.

Working capital management

Most big firms use loans obtained from banks to operate in order to make a greater amount of profit and when the moment of returning the loan comes, they should be able to refund the loan. Therefore in working capital management the firm puts in place various techniques through which the debts they owe can be paid respecting the deadlines by managing the short term current assets to meet up with the short term current liabilities and at the same time make profits. It is well known that investments in long term capital projects are those that yield the more profits and are those companies should go for. It is difficult for a firm to get large amounts of money to invest on long term projects if they have not yet proven their effectiveness to the bank issuing them the loan.

Effective capital management for the day to day running of short term investment projects in a firm can be seen as a start that builds up the atmosphere that will open them the doors for the king of loans given for long term investment that are more profitable. Moreover when a company has a good working capital management, the firm will be healthy in terms of profitability, and by so doing they develop a good structural functioning of the company.

The different bodies of working capital management

Usually, the financial manager of a company faces the difficulty of evaluating all the components of working capital at the same time. This is due to the fact that the rate of purchase of the goods produced by the company by the customer cannot be controlled or predicted accurately so that the income from the purchase can be used to pay current liabilities. The firm needs to manage their working capital such that the short term cash needs of the company can be met to ensure continuous production and the company would not make losses. There are various working capital management components that make a firm efficient in production when well handled and hence, make profits when they are applied:

a)      Cash and cash equivalence

How much a company has as its maximum liquid asset balance is determined on how efficient the cash is managed. The maximum cash in hand will determine how much the company has to get into new investment projects in a short term to make quick profits. The aspect of good cash and cash equivalence also means that the firm maintains the right liquidity and has minimum cash in the bank. For a company to be able to pay all its debts when the time is due, they need to know how to manage the cash in hand and so working capital management of cash can prevent insolvency and make the company keep a good status towards its creditors; so that the cash flow and the profitability of the firm keeps growing.

b)      Checking and making inventories

The aspect of inventory is a component of working capital that involves the financial manager in the control where money seeks to accumulate in the firm that might create a loss of profit to the company. The raw materials, the work in progress (WIP) as well as the finished goods are the various sectors on which the inventory of the firm is made. Inventory on the raw material will be to know if the raw material available is small in a way that it won’t meet production or know if much raw material has been bought and there is no need of accumulating more cash on them and redirecting the money on another sector. This means the inventory made is a kind of working capital management seeking to meet the balance of production.

c)      The need to manage accounts payable

The individuals that provide capital to the firm in the form of credit or loans are very important to the firm and so managing their money properly is vital to the survival of the company. They are responsible to flow in cash in case of new business ventures and so when the time of payment to the creditor is due it is proper to refund the money on time so that trust is built for the growth and profitability of the firm. In this like the factors to be taken into consideration in this kind of working capital management; how costly is the credit given to the firm (interest rate); good inventory to meet up with the payment; adopting a good strategy for customers to pay for goods as fast as possible like e-commerce.

d)      The concept of money and time

In working capital management, the dimensions which are money and time are key factors that are to be considered at any stage of the firm activities. For example there is a time to make inventories so as to make sure production is efficient, time to make payables so that production is not stopped and there is a time to receive payments for the finished products. In all these stages there is cash involved in executing the various activities.

Gross working capital

A list of all the current assets in a firm constitute the gross working capital of that firm and when they are more than the current liabilities of that firm they turn to be profitable to the firm. In this like, we have as gross capital of a company it’s checking and saving account balances, the cash in the firm, the amount as receivables and also the short term investment. If the current liabilities are deducted from the gross working capital and the net working capital obtained is positive, then the firm is working at a profit.

Effects of the excess and inadequate gross working capital

As gross working capital is used for the production of goods and services in a firm, evaluating the right amount needed for optimum production will make the firm produce at a profit.

The draw backs of the firm having excess gross working capital

There is a reduction in the efficiency of capital to a firm when there is an excess gross working capital that is not reinvested and does not work for the profit of the firm. This implies the rate of return to the firm is subsequently not optimum. It has been observed that when there is excess gross capital in a firm there is the tendency of purchasing more of inventories and accumulating them. This can result in the wastage or the loss of the purchases. There is a fear of fall in the value of shares if the optimum production drops and less return on investment.

Negative effects of inadequate gross working capital

If inadequate gross working capital exist in a company, the company will not be able to pay its current liabilities on time and this will affects its image towards its creditors and might restrict expansion of business in case of a new business opportunity.

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