Working capital is a financial meter which depicts operating liquidity available to an organization, business or other entity, including governmental entity. Together with fixed assets such as equipment and plant, working capital is also considered a member of operating capital. Current assets equals to gross working capital. Mathematically, Working capital is expressed as;
Working capital=current assets-current liabilities.
If current liabilities are greater than current assets, an organization has a working capital deficiency (working capital deficit).
A company can be endowed with profitability and assets but lacks liquidity if its assets cannot readily be transformed into cash. Positive working capital is required to ensure that a company is able to carry on with its activities and that it has enough funds to satisfy both upcoming operational expenses and maturing short-term debt. The management of working capital entails managing accounts receivable and payable, inventories and cash.
The working capital cycle is the period of time it takes to turn the current liabilities and net current assets into cash. The longer the cycle is, the longer a business is accumulating capital in its working capital without receiving a return on it. Thus, companies seek to reduce their working capital cycle by sometimes stretching accounts payable or by collecting receivables quicker.
A positive working capital cycle matches incoming and outgoing payments to maximize free cash flow and reduce net working capital. For instance, a company that pays its suppliers in 30 days but takes 70 days to collect its receivables has a working capital cycle of 40 days. This 40-day cycle often needs to be financed through a bank operating line, and the interest on this funding is a carrying cost that decreases the company's profitability. Growing businesses require money, and being able to free up money by reducing the working capital cycle is the cheapest way to grow. Sophisticated purchasers review closely a target's working capital cycle because it gives them an idea of management's effectiveness at generating free cash flows and managing their balance sheet.
As a rule of thumb of funders, each of them wants to witness a positive working capital. Such scenario gives them the possibility to think that your establishment has more than enough current assets to cover financial dues. Though, this is not true for negative working capital. A considerable number of funders believe that businesses cannot be sustainable with a negative working capital. This is a wrong thinking approach. In order to operate a sustainable business with a negative working capital, it is necessary to understand some key elements.
- Effectively observe your inventory management. Make sure that it is usually refilled and with the aid of your supplier, stock your warehouse.
- Persuade your suppliers to let you purchase the inventory on 1 to 2 month credit terms, but remember that you must sell the purchased goods to clients for money.
Working capital depicts short-term assets available to a company to meet up with financial obligations such as creditors, suppliers and payroll. A company with small working capital can have liquidity issues even when their asset profitability and position is healthy. Manufacturing companies are subject to working capital problems because production and supplier expenses often require payment several months in advance before commodities are sold to customers.
Working Capital Management for Manufacturers
Working capital is close to the top of the list among business issues currently faced by manufacturing companies. The only problem ranked as a more serious concern — rising costs which is also directly linked to cash flow and working capital. Working capital management by manufacturers and other kinds of businesses is designed to resolve and anticipate such issues before they cause normal payments to be delayed. Financial managers of manufacturing companies have several potential plans to review for cash flow amelioration. Two of these are asset financing and lean manufacturing.
The concept of a lean company was first applied in the manufacturing industry and has been extended to other businesses beyond primitive manufacturers. Nevertheless, the gains of lean manufacturing processes are useful for ameliorating liquidity and cash flow. A lean manufacturer has an ongoing objective of reducing unnecessary costs and wastes throughout the manufacturing process. Fewer financial resources are needed as lean management goals are achieved and this leads to improved working capital. However, reducing costs might not be enough to keep constant, the positive cash flow for a manufacturer.
An ongoing problem for any company and especially for manufacturing enterprises is to reduce the delayed timing between and receiving payment when those products are sold and spending resources for producing goods. Even when a manufacturer makes a sale, the customer usually will not pay for the merchandise immediately. Accounts receivable represent cash which are due from business clients but are yet to be paid. Slow-paying clients and extended payment terms both become a potential cash-flow shortfall until payments are made. Asset financing is a financial strategy that permits manufacturers to receive finance from their accounts receivable before customers make their payments. This can be a time-bound solution for manufacturing companies to use when they face excessive delays in receiving payments. Asset financing costs can vary widely, and a due diligence inspection of financial terms is of prime importance.
Bank Lines of Credit
Manufacturers also can find a working capital line of credit from primitive commercial lenders such as banks. However, credit line services have been halted by many lending institutions in favor of other financial agendas. Smaller manufacturers generally will have different borrowing options than larger manufacturing businesses. While alternative working capital financing is present for manufacturers of all sizes, in-depth research can be necessary before you start seeking the most effective solution.