Meaning of Working Capital Management
Working capital management is a process of managing working capital requirements of an organization for smooth functioning. Working capital is simply the cash required for meeting daily expenses and for operation of day to day activities. Management of working capital involves managing current assets and current liabilities of business for attaining better liquidity position.
It mainly focuses on always maintaining sufficient amount of cash in an organization to easily meet its short-term debts and operating expenses. This process is not only concerned with maintaining proper liquidity in business but also with working capital financing. It aims at economical procurement of working capital required and efficient utilization of that capital to derive better results.
Working capital management performs ratio analysis of key elements of operating expenses such as inventory turnover ratio, working capital ratio and collection ratio. It aims at maintaining these three ratios at an optimum level which helps in smooth functioning of business.
Classification of Working Capital Management
Classification/ Approaches of Working Capital Management:-
- Hedging approach: This approach of working capital management is also termed as matching approach. According to hedging approach, company should finance their permanent current assets or fixed assets using long term funds. Whereas for acquiring temporary current assets, short term funds should be used.
- Aggressive approach: As per aggressive approach company tends to take high risk as it always depends on short term funds. For financing current assets and even some fixed assets, funds from short term sources are used under this approach. It reduces the cost of loan. However the degree of risk involved increases as company has funds only for financing current needs or a specific production level. It fails to raise a working capital loan in case of any variations arises in working capital needs.
- Conservative approach: Under conservative approach, long term sources of funds are used for acquiring both fixed assets as well as current assets. This policy decreases the degree of risk involvement whereas cost of loan rises. It is termed as conservative because here company prefers to maintain sufficient fund at all the times.
Scope of Working Capital Management
Scope of Working capital management is as given below:–
- Ensures business continuity: Working capital management enables business in continuing their activities uninterrupted. Proper management of working capital will lead to availability of sufficient funds at all times. Business will receive regular supply of raw materials from supplier by paying them on time which will help in continuing production activities regularly.
- Improves business solvency: Business managing their working capital efficiently are able to maintain proper liquidity. It will improve their cash management and will reduce their dependency on external financing as large amount of funds is tied up in working capital. Management of working capital will enable them in paying all short-term debts and operating expenses on time.
- Ability to face crisis: Efficient management of working capital enables business in facing emergency situations such as depression. It ensures proper availability of funds at all times so that business can easily face time of crisis or peak demand where they need to boost up their production.
- Increase creditworthiness: Improving the business value and position in market is another important advantage of working capital management. Businesses having sound working capital position enjoy better liquidity and credit rating. It helps them in raising funds from various external sources easily at favorable terms.
- Better relations with supplier and creditors: Management of working capital leads to better relations with supplier and all creditors. It enables business in paying all dues to suppliers or trade creditors on time through always maintaining sufficient amount of funds. This will result in gaining confidence of creditors towards business.
- Helps in expansion: Every business wants to expand its activities over the time for which it needs additional capital. Proper management of cash will provide business with necessary funds timely and make expansion programs successful.
- Competitive advantage: Business through management of funds is able to reduce their cost and avoid wastages of resources. They can earn sufficient profits by offering their products even at low prices to customers. It will help in gaining competitive advantage in market and generating large revenue.