Relationship between working capital management and business solvency

relationship between working capital management and business solvency

relationship between working capital management and firm performance in detail . corporate profitability and working capital management for firms listed at. relationship between working capital and profitability of Indian pharmaceutical of working capital management policies on corporate performance of Indian. Efficient Working Capital Management allows a firm to manage its short-term and is often defined as the difference between current assets and current liabilities. Liquidity is often tight in small businesses due to the scale of their Higher Return on Capital; Improved Credit Profile and Solvency.

Working capital management could vitally affect the health of the firm Sagan, Industry practices, company size, future sales growth of company, the proportion of outside directors on a board, executive compensation current portion and CEO share ownership significantly influence the working capital management efficiency of a company. Working capital management involves planning and controlling current assets and current liabilities in a manner that eliminates the risk of inability to meet due short term obligations on the one hand and avoid excessive investment in theses assets on the other hand Eljelly, As a result, companies can minimize risk and improve their overall performance if they can understand the role and determinants of working capital.

A firm may choose an aggressive working capital management policy with a low level of current assets as percentage of total assets or it may also be used for the financing decisions of the firm in the form of high level of current liabilities as percentage of total liabilities Afza and Nazir, Keeping an optimal balance among each of the working capital components is the main objective of working capital management.

Business success heavily depends on the ability of the financial managers to effectively manage receivables, inventory and payables Filbeck and Krueger, Firms can decrease their financing costs and raise the funds available for expansion projects by minimizing the amount of investment tied up in current assets. An optimal level of working capital is a balance between risk and efficiency.

It ask continuous monitoring to maintain the optimum level of various components of working capital, such as cash receivables, inventory and payables Afza and Nazir, A popular measure of working capital management is the cash conversion cycle which is defined as the sum of days of sales outstanding average collection period and days of sales in inventory less days of payables outstanding Keown, The longer this time lag, the larger the investment in working capital.

A longer cash conversion cycle might increase profitability because it leads to higher sales. However, corporate profitability might also decrease with the cash conversion cycle, if the costs of higher investment in working capital is higher and rises faster than the benefits of holding more inventories and granting more inventories and trade credit to customers Deloof, Efficient management of working capital plays an important role of overall corporate strategy in order to create shareholder value.

Working capital is regarded as the result of the time lag between the expenditure for the purchase of raw material and the collection for the sale of the finished good. The way of working capital management can have a significant impact on both the liquidity and profitability of the company Shin and Soenen, The main purpose of any firm is maximizing profit.

Importance of Working Capital Management

But, maintaining liquidity of the firm also is an important objective. The problem is that increasing profits at the cost of liquidity can bring serious problems to the firm. Thus, strategy of the firm must be a balance between these two objectives.

Because the importance of profit and liquidity are the same so, one objective should not be at cost of the other. If profit is ignored, we cannot survive for a longer period. Conversely, if we do not care about liquidity, we may face the problem of insolvency. For these reasons working capital management should be given proper consideration and will ultimately affect the profitability of the firm. Determinants of working capital: There are no specific set of rules or formulae to determine the working capital requirements of firms.

A large number of factors, each having a different importance influences working capital needs of firms.

relationship between working capital management and business solvency

The following is the description of factors which generally influence the working capital requirements of firms Adeniji, Working capital requirements of a firm are basically influenced by the nature of the business. In practice, trading and financial firms have a very small investment in fixed assets but require a large sum of money to be invested in working capital.

There is a relationship between volume of sales and the working capital needs of an organization. However, it is difficult to precisely determine the relationship between volume of sales and working capital needs.

In practice, current assets will have to be employed before growth takes place.

relationship between working capital management and business solvency

The production process has a lot of impact on the working capital requirement. The manufacturing cycle comprises of the purchase and the use of raw materials and the production of finished goods. The credit policy of the firm affects the working capital by influencing the level of debtors.

The credit terms to be granted to the customers may depend upon the norm of the industry to which the firm belongs. This relates to the optimum utilization of resources at minimum costs. That is why, fixed and part of current assets are financed by long-term or permanent funds. The Company wants to take high risk where short term funds are used to a very high degree to finance current and even fixed assets.

Importance of Working Capital Management |

Classification of Working Capital: This helps to take into account unforeseen events such as changes in the market conditions and competitor activities.

Working Capital in adequate amount: For every business entity adequate amount of working capital is required to run the operations. It needs to be seen that there is neither excess nor shortage of working capital. Both excess as well as shortage of working capital situations are bad for any business. However, out of the two, inadequacy or shortage of working capital is more dangerous from the point of view of the company operations.

Inadequate working capital has its disadvantages where the company is not capable to pay off its short term liabilities in time, difficulty in exploring favorable market situations, day to day liquidity worsens and ROA and ROI fall sharply. On the other hand, one should keep in mind that excess of working capital also leads to wrong indications like idle funds, poor ROI, unnecessary purchase and accumulation of inventories over required level due to low rate of return on investments, all of which leads to fall in the market value of shares and credit worthiness of the company.

The working capital cycle WCC is the amount of time it takes to turn the net current assets and current liabilities into cash.

  • Factors effecting working capital:
  • Working capital Approaches:

The longer the cycle is, the longer a business is tying-up funds in its working capital without earning any return on it. This is also one of the essential parameters to be recorded in working capital management.

Working Capital Management WCM refers to all the strategies adopted by the company to manage the relationship between its short term assets and short term liabilities with the objective to ensure that it continues with its operations and meet its debt obligations when they fall due.