Importance Of Working Capital During Recession
The economic and credit crisis of 2008 has forced many companies into cash flow problems due to non availability of working capital and credit facilities which in turn have led to retrenchment of staff, shrinkage of operations, curtailment of plans for capital expansion into different markets and downsizing. For most of these companies such a curtailment of operations and credit crunch threatens their very existence. To overcome this problem companies look up to finance professionals who can manage the working capital requirements through planning, obtaining additional facilities and restructuring their operations. Working capital management is one of the cornerstones of business continuity and acts as a hedge against tightening credit and access to additional capital. Companies which manage their working capital optimally during times of recessions come out stronger post the recession period.
During times of double digit growth and expansions it is easy to forecast working capital needs and manage liquidity. The real test however comes during periods of recession and credit crisis as witnessed by the world during 2008 and 2009. During these times the management and finance professionals need to devote themselves to reassessing the organization’s working capital sources and needs, such as how to finance the working capital, what is the level of financing required in downturn and what are the costs of obtaining the working capital.
What is working capital?
Working capital, also known as net working capital, represents operating liquidity available to a business. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. It is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency.
Working Capital = Current Assets − Current Liabilities
A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable, payable and cash. These components provide the sources of income for the business, whether in the form of profit from the sale of products and services, or interest earned from securities. The current liabilities consist mainly of accounts payable which is of prime importance as management of payables can significantly affect cash flows of the company.
Effective working capital management is ensuring sufficient cash flow to fund operations while reducing debt. Working capital management is the responsibility of all the departments in the organization i.e. finance, sales, purchasing, planning, manufacturing etc., also known as the cash conversion cycle.
The important aspects of working capital management are:
1) Planning - Companies should begin by determining what their working capital requirements should be and tune the working capital model accordingly. The model could be aggressive or moderate based on the market situation affecting the company. Assessing the risks present and future, also plays an important part in planning for the working capital requirements.
2)Reassess internal working capital policies such as credit periods for customers, suppliers, short term finance, long term finance, equity participation, inventory, securities etc.
3)Benchmarking-Companies should benchmark their requirements against similar companies in their industries to have information on working capital requirements.
4)Balance growth and profitability- Companies should balance growth with profitability with sound working capital policies.
To be successful, working capital and cash management initiatives require buy-in and support from senior levels of management and logically, should be led by the Chief Financial Officer, or in some cases, the Chief Executive Officer. Dramatic improvements in working capital are possible. The best organizations are shifting their focus to a more strategic approach to the finance function, by taking responsibility for performance improvement initiatives that have a direct link to enhancing the economic value of the organization.
Improving your business’s cash-flow management system is critical to freeing up your capital and using it to your advantage. These operational improvements can contribute to strategic success and help sustain your competitive advantage.