Managing a company’s working capital means keeping track of its current assets and debts. The goal of managing current assets and liabilities, also called “working capital,” is to keep things in good shape. In the normal course of business, the current assets of a company are turned into cash. The goal of good management of working capital is to keep the level of working capital just right, not too high or too low. Working capital that is too high or too low can hurt the productivity of a business. A business can lose money if its work-in-progress funds are too low or too high. Because of this, it’s important for a business to put some money aside every month for operational costs. In this article, we will discuss about sources of working capital in financial management in brief with examples for your better understanding.
Working capital management is the process of taking care of a company’s cash and short-term debts. The main focus here is on the problems that come up when dealing with both current assets and current liabilities, as well as how they relate to each other. The goal of managing a company’s working capital is to make sure that its liquid assets are just high enough to cover its current debts. Working capital risks can come from having too little or too much working capital. If there isn’t enough money, production may have to stop.
Top 12 – Sources of Working Capital in Financial Management
The main goal of working capital management is to make sure that there is always enough cash on hand to pay for the company’s immediate operational needs and debt service obligations. The difference between a company’s current assets and liabilities is its working capital. Anything that can be turned into cash quickly and easily within a year is called a current asset.
These are the company’s most liquid assets. Current assets include money in the bank, money owed to you, stock on hand, and investments with a quick return. Current liabilities are debts that must be paid off within a year. This section shows how much money has been set aside for operating costs and long-term debt payments. Check out these sources of working capital in financial management to broaden your horizons.
Managing Liquidity
A company is managing its liquidity well if it has enough cash on hand to pay for both expected and unexpected costs. It is important because it affects a company’s creditworthiness, which in turn affects its financial health. If everything else stays the same, a company is more likely to get into financial trouble the less liquid it is.
On the other hand, putting too much money into assets that don’t bring in any money could be a sign of mis-allocation. A company that has done a good job of managing its liquidity either has enough cash on hand or can quickly and easily make enough cash to meet its financing needs.
Trade Credit
When people talk about “trade credit,” they mean the terms of financing under which items are bought in normal business transactions. Because credit is the basis of business today, a trade credit arrangement between a company and its suppliers is a must-have way to get working capital.
Trade credit is mostly based on how reliable a company is and how well it can keep its suppliers’ trust. Sources of working capital in financial management refer to the methods through which organizations can obtain funds to finance their day-to-day operations.
Dividend Policy
A dividend is a distribution of earnings that lowers the amount of retained earnings. The working capital of a company is directly affected by the ratio of dividends paid out and the profit margin. When the net profit margin goes up, the company could use that money to get more working capital.
A big dividend payment would hurt the company’s ability to pay bills and reduce its working capital by a lot. By sticking to a conservative dividend policy, management can lower the company’s need for extra working capital.
Commercial Paper
To quickly obtain cash, businesses issue commercial paper, which are promissory notes that don’t require repayment. This financial tool is important on the financial markets of developed countries like the US. In response to suggestions from the Money Market Working Group, the Reserve Bank of India added commercial paper to the Indian money market (Vague Committee).
But only big companies with good credit and good financial health can sell commercial paper to get short-term cash. Most Indian commercial paper has a maturity of between 91 and 180 days. The bond is sold for less than its face value and can be bought back at maturity for its face value.
Payday Loans / Commercial Banks
Some businesses get money up front from customers and agents in exchange for orders, and they use that money as working capital. It is a cheap way to put money in the bank. Commercial banks most often give short-term loans. They make most loans for working capital.
They can change their financing options to fit any business’s needs and offer flexibility. Factoring, which involves selling accounts receivables to a third party for a discounted price, is a source of working capital in financial management.
Managing Inventory
Inventory management aims to balance having enough stock to meet regular and seasonal demand while avoiding excess cash tied up. Having a lot of cash on hand is linked to having too much inventory. Stockpiling increases the risk of unsold items losing value. Avoiding stock shortages is crucial to prevent losing sales and money.
Paid out Later
Delayed earnings are money that comes in before the delivery of goods or services. In other words, they show how much money a company has received in preparation for selling something in the future.
In addition to being a large source of short-term funding, these funds also make a company more liquid. Businesses with high demand and good market reputation can negotiate payment deferrals. Equity financing, which involves selling shares of a company to investors, is a long-term source of working capital in financial management.
Installment Credit
Another way to get assets and goods right away but pay for them over time. Most of the time, interest is added to past-due balances or is part of the price being asked. No matter what, it gives you temporary access to money and is a key source of working capital for many businesses that are having trouble making ends meet.
Indigenous Bankers
Before commercial banks came along, the only ways to get a loan were through private money tenders or other country bankers. They used to take advantage of their customers by charging them very high interest rates.
Since new financial institutions have grown, commercial banks are no longer the most important. Still, a lot of businesses still borrow money from their local banks for short-term needs. Debt financing, which involves borrowing funds from lenders, is another long-term source of working capital in financial management.
Keeping Track of Accounts Receivable
Ensure a steady cash flow while providing appropriate commercial credit to customers. Set customer credit terms based on factors such as customer financial stability, industry standards, and competitor practices.
Credit terms usually allow customers between 30 and 90 days to pay an invoice. Payment terms, such as cash in advance, cash on delivery, bill to bill, and recurring billing, can vary based on company policy and managerial discretion.
Credit for Accounts Receivable
Accounts receivable credit is another way to get cash quickly. This is available through commercial banks and factoring. A commercial bank may lend money to its customers by giving them a discount on bills or invoices they owe the bank. So, a company can quickly get paid for sales made on credit.
A factor is a type of financial organization that helps manage and finance sales on credit. Personal savings and loans from friends and family are sources of working capital in financial management for small businesses and start-ups.
Handle Short-term Debt
The objective of short-term financing management aligns with liquidity management, ensuring sufficient cash on hand to cover immediate needs and minimize risks. Effective short-term financing involves selecting appropriate cash-generating methods and determining the potential cash inflow from each.
You can obtain capital through credit lines, collateralize loans, and factoring, among other methods. When business is good, it’s important for a company to have enough cash on hand to pay its bills. A company may establish a large revolving credit agreement to access quick cash in emergency situations.
Frequently Asked Questions
What is the most Important Part of Managing Working Capital?
Working capital management’s two most important goals are to keep the working capital operational cycle going and to make sure it runs smoothly. Another goal is to reduce the cost of working capital while increasing the return on investments in current assets.
In Financial Management, What are the Sources of Working Capital?
Long-term sources of working capital include long-term loans, provisions for depreciation, retained earnings, debentures, and share capital. Quick sources of operating capital include dividends and tax provisions, cash credits, and public deposits.
Why do you Need Working Capital?
Your company’s working cash affects everything from paying employees and suppliers to keeping the lights on and making plans for long-term, sustainable growth. Working capital is the money a business has on hand to pay its bills and costs in the short term.
Conclusion
The goal of managing working capital is to keep it at the right level, which is neither too high nor too low. Working capital that is too high or too low can hurt the productivity of a business. A business can lose money if its work-in-progress funds are too low or too high. Because of this, it’s important for a business to put some money aside every month for operational costs. Continue reading to become an expert on sources of working capital in financial management and learn everything you should know about it. To explore purpose of financial management topic from a historical perspective, read this engaging post.
