WHAT IS WORKING CAPITAL?

In the daily and financial life of the company, the administration of working capital is of the utmost importance and although many small and medium-sized companies do not have it well defined, we live applying concepts of working capital day by day.

In general, small businesses or large companies have a common goal, which is to maximize the value of their company. To achieve this, we must learn to efficiently manage current assets and short-term liabilities, that is, the company’s resources.

The resources are all those destined to cover the cost of the daily operation and the necessary tools to be able to operate.

The management of working capital is the function of financial administration that is dedicated to the planning, execution, and control of the management of the components of working capital and its adequate levels and quality, which allow for minimizing risk and maximizing business profitability ( D. Espinosa, 2005).

Let us explain then what is the importance of working capital in a company and the problem of the insufficiency of its good administration. Let’s start by remembering that this concept is directly related to the liquidity condition of the company, taking into account the degree of liquidity of each current asset and how much each current liability requires. This means that the company has a greater capacity to pay its debts when due when the greater the margin in which the short-term assets of a company cover its short-term obligations.

A fundamental element to take into account with respect to the adequacy of working capital is that it provides the company with the capacity to conduct its operations on the most economical basis and without financial restrictions and to face emergencies and losses without the danger of a financial disaster. Likewise, this adequacy allows for granting favorable credit conditions to clients, operating more efficiently without delays in obtaining materials, services, and supplies due to credit difficulties and enduring periods of depression.

Insufficient working capital may also be caused by excessive losses from abnormal or extraordinary operations, which may cause a reduction in the values ​​of current assets or the creation of current liabilities (none of these circumstances can be offset by a favorable change in working capital)

The business cycle affects working capital needs, as during periods of prosperity, business activity expands, and there is a tendency to purchase merchandise in order to take advantage of lower prices.

Consequently, a greater amount of working capital will be necessary. Likewise, as the volume of operations expands, the amount of working capital required becomes greater, although not necessarily in exact proportion to the growth.

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Small businesses generally strive to optimize the use of resources but these concepts have not been established and are often downplayed and are not prepared for the long term, so when there are periods of scarcity it is difficult to deal with the debts.

The following concepts are considered sources of Working Capital:

  • Normal operations, through depreciation, depletion, and amortization.
  • Sales of fixed assets, long-term investments, or other non-current assets.
  • Sales of bonds payable and stocks of capital and contributions of funds by the owners.
  • Trade credits (open accounts, trade acceptances, and notes payable)
  • Reimbursement of income tax and other similar extraordinary items.

COMPONENTS OF WORKING CAPITAL

As we mentioned before, it implies the management of current assets and short-term liabilities: it is defined as the result of the difference between these two.

Working Capital = Current Assets – Current Liabilities

The result that it gives us will indicate the amount of money with which we are operating in the company. For this reason, when the Current Assets are greater than the Current Liabilities, we have a Positive Working Capital. When the Current Assets are the same as the Current Liabilities, we have a Null Working Capital.

Current Assets:

This group is made up of all the assets and rights of the business that are in constant rotation or movement and whose main characteristic is an easy conversation in cash. The order in which the main accounts must appear in Current Assets, based on their greater and lesser degree of availability, is as follows:

Cash · Banks · Raw material · Clients · Notes receivable · Miscellaneous debtors

Current Liabilities:

It is made up of all debts and obligations whose maturity is in a period of less than one year; Said debts and obligations have as their main characteristic that they are in constant movement or rotation.

The main debts and obligations that make up current liabilities are:

  • Suppliers
  • Documents to pay
  • Various creditors

IMPORTANCE OF WORKING CAPITAL

“The importance of efficient working capital management is unquestionable, since the viability of the company’s operations depends on the financial manager’s ability to efficiently manage accounts receivable, inventory, and accounts payable” (Gitman & Zutter, 2012)

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The main function of the optimal management of working capital is to have control of the asset accounts and to have a balance between risk and profitability, for these reasons, the personnel in charge of the administration of the working capital must consider a considerable part of the time to such matters. Research “with financial managers from companies around the world indicates that working capital management tops the list of most valuable finance functions.” Emphasizing this background, it is important to mention that working capital is important due to the time that the manager dedicates to it.

The importance of good working capital management today is due to the fact that many companies continually enter and exit the market, one of the main causes for companies to leave the market is the lack of liquidity to be able to solve their daily activities.

It is important to understand where companies obtain resources, the main sources of financing for a company are: financing from suppliers, and banks, among others, when acquiring an obligation, companies are obliged to cover their responsibilities in a certain time, in addition to being able to finance.

The company with working capital financing offers us other tools that are essential for the company. With this small table, we can visually understand the importance of good working capital management.

As we can see in the small table from the moment the purchase of raw materials is made until collection, it is known as the financial cycle, the financial cycle is the period of time required to acquire inventories, sell them, and collect them, within this Find the cash cycle. This includes the period from when payments are made to suppliers until cash collections are made.

The effective management of working capital generates the liquidity required by the company to meet with solvency the obligations with suppliers and labor benefits, avoiding the company from falling into technical insolvency.

For Jiménez et al (2013), the importance of working capital lies in knowing the time that money spends in accounts receivable and inventory, until its recovery. Good working capital management can be carried out with good collection, payment, and inventory policies.

WORKING CAPITAL POLICIES

The working capital policies always hand in hand with the assets and liabilities of the company. These policies can take us down different paths and towards a point where the company can enter a comfort zone since it has adapted in the right way and it has worked.

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Before choosing a policy for our company and knowing what suits us, the author “Giovanny López” invites us to look at 3 specific and fundamental points:

  •  “Level set as a goal for each category of Current Assets.
  •  The way in which these Current Assets will be financed (level of Current Liabilities).
  •  The effects of these levels on the alternative Risk – Return”

It is necessary to take these points into account since as a result of this is how we will make the decision of which policy is best for our company and which one will help us grow in the best way since there cannot be only one since every company is different. , has different things and situations, as well as other goals.

The policies that we can take into account are:

Relaxed policy: the relaxed policy is based on a “big cash” amount and inventories, so that sales can grow based on a liberal policy on credit issues, this can help us a lot since it would help us to have a level high accounts receivable, so it would result in us having low levels of risk but equally profitable.

Restricted policy: this policy binds the risk policy of the company and its profitability to rise since it is based on the fact that cash, and inventories,  decrease and thus we have small amounts of current assets.

Moderate policy: it is a combination of the previous policies, therefore the levels of risk and profitability will be compensated and thus a balance can be found, where the company can be maintained.

REFERENCES

  • Ámbar A. and Espinosa, D. (s/a) Working Capital Management as a process of Operational Financial Management. Retrieved on May 7 from http://www.elcriterio.com/revista/ajoica/contenidos_4/ambar_selpa_y_daisy_espinosa.pdf
  • García Aguilar, J., Galarza Torres, S., & Altamirano Salazar, A. (2017). Importance of efficient management of working capital in SMEs. // Importance of efficient management of working capital in SMEs.  Ciencia Unemi, 10 (23), 30-39. Retrieved from http://ojs.unemi.edu.ec/index.php/cienciaunemi/article/view/495/387
  • Jaramillo Aguirre Sebastian. (2016). Relationship between working capital management and profitability in the chemical distribution industry in Colombia. April, 30,2018, from redalyc Website: http://www.redalyc.org/pdf/3235/323547319006.pdf
  • Lorenzo, R., Pablos Solís, P. and Lorenzo, R. (2010) The theory of working capital and its techniques. in Contributions to the Economy. Retrieved on May 7, 2018, from: http://www.eumed.net/ce/2010a/
  • Gomez Giovanny. (2001, January 11). The administration of working capital. Retrieved from https://www.gestiopolis.com/administracion-capital-trabajo