The management of working capital is the function of the financial administration that is dedicated to the planning, execution and control of the management of the components of the working capital and its adequate levels and quality, which allow minimizing risk and maximizing business profitability (D. Espinosa, 2005).
This is one of the most important functions of the financial manager, and to which he generally dedicates a large percentage of his time. The objective of this article is to explain the importance of Working Capital, the need for companies to rigorously follow their management and the problem of the sufficiency and insufficiency of Working Capital.
Development
The unsynchronized nature of cash flows, that is, of money inflows and outlays, is one of the fundamental elements that affect the need for companies to maintain working capital. The company's cash flows resulting from the payment of current liabilities are relatively predictable. Likewise, it is possible to predict what is related to documents payable and accrued liabilities, which have specific payment dates. What is difficult to predict are the company's future cash inflows.
It is quite difficult to predict the date on which current assets other than cash and other marketable securities can be converted into cash. The more predictable these cash inflows, the less working capital the company will need (L. Gitman, 1986; F. Weston and E. Brigham, 1994).
The foregoing explains that the existence of working capital is closely related to the liquidity condition of the company, however, the degree of liquidity of each current asset and the degree of enforceability of each current liability cannot be lost sight of (A. Demestre et al., 2002), which supports the idea that the greater the margin in which the short-term assets of a company cover its short-term obligations, the more payment capacity it will generate to pay its debts at the moment of its expiration.
This expectation is based on the fact that current assets are sources of cash inflows, while current liabilities are sources of cash outlay. Since most companies cannot match cash receipts with money disbursements, it is necessary that the sources of income exceed the disbursements.
Other criteria on the importance of working capital are provided by different authors; among these reasons are:
- High participation of current assets in the total assets of companies, which is why the former require careful attention (F. Weston and E. Brigham, 1994). It avoids imbalances that are the cause of strong liquidity tensions and situations that force suspend payments or close the company due to not having the necessary credit to face it (E. Santandreu, 2000). A large part of the time is dedicated by most financial managers to the daily internal operations of the company, which fall under the realm of working capital management (F. Weston and E. Brigham, 1994). The profitability of a company can be affected by excess investment in current assets (A. Demestre et al., 2002). It is inevitable investment in cash, accounts receivable and inventories,although it is in plants and equipment that can be leased. This is coupled with the fact that at times, access to the long-term capital market is difficult, so there must be a solid foundation in commercial credit and short-term bank loans, all of which affect working capital (F Weston and E. Brigham, 1994). There is a close and direct relationship between sales growth and the need to finance current assets, a relationship that is perceived as causal (F. Weston and E. Brigham, 1994; Van Horne and Wachowicz, 1997 and A. Demestre et al., 2002) The survival of the company, translated into its ability to cover its short-term obligations as they expire, or the probability of being technically insolvent, which boils down to risk,it depends on the adequate management of working capital (A. Demestre et al., 2002). Existence of “current investments that must be financed with permanent funds” (E. Santandreu, 2000). These investments are essentially:
- Security stock; that is, permanent stock in the company to maintain the correct rotation without interruptions and an adequate profitability index. Part of the treasury that must remain immobilized for some reason (example: retention accounts and financial investments).
- It fulfills two functions, one economic and the other financial. In its economic function, it can be considered as complementary and heterogeneous production goods that contribute to the creation of products and services by the company.
Its financial function includes achieving an adequate relationship between the rhythms of liquidity and enforceability of current assets and liabilities respectively, guaranteeing solvency (ML Lara et al., 2005).
For RD Kennedy (1999) and ML Lara et al. (2005), the working capital needs of a business depend on some factors that will be related below.
The general nature of the type of business determines the needs for working capital since these vary depending on the type of activity carried out. For example, in a utility company investments in inventories and accounts receivable are quickly converted into cash; however, an industrial company has to invest more in them and their rotations are relatively slow, requiring a greater amount of working capital.
Likewise, businesses with seasonal sales will require a maximum amount of working capital for a relatively short period. Such a business will typically have a working capital surplus during the off-peak sales period.
Coupled with the above, the business cycle affects working capital needs, as during periods of prosperity, business activity expands, and there is a tendency to buy merchandise in order to take advantage of lower prices.
Consequently, a larger amount of working capital will be required. Likewise, as the volume of operations expands, the amount of working capital required becomes greater, although not necessarily in exact proportion to growth.
The time necessary to manufacture or obtain the merchandise to be sold and the unit cost of the same plays a fundamental role, since the longer the time required to manufacture the merchandise or to obtain it, the greater amount of working capital is required. will require, as well as as the unit cost of it is higher.
With regard to the conditions of purchase and sale, the more favorable the credit conditions in which the purchases are made, the less cash is invested in the inventory. On the other hand, the more liberal the credit conditions granted to clients, the greater the amount of working capital that will be represented by accounts receivable.
The rotation of inventories and its analysis is essential, since the greater the number of times that inventories are sold and replaced (inventory rotation), the lower the amount of working capital that will be required, the lower the risk of losses due to price drops, changes in demand or style and lower cost of carrying inventories.
Likewise, the turnover of accounts receivable has a significant influence on working capital needs because it depends on the time required to convert them into cash. The less time it takes to collect these accounts, the lower the amount of working capital that will be needed.
The degree of risk of a possible drop in the value of current assets influences the needs of working capital, which the higher it is, the greater the necessary amount of it that must be available in order to maintain the credit of the company. To deal with this contingency, a relatively large amount of cash or temporary investments must be maintained.
It is important to note that the growth of companies leads to the need for additional capital for investments in accounts receivable, inventories and fixed assets. Part of this capital in most cases is obtained from internal sources, but if the growth rate is accelerated, part of it will come from external sources (Y. García, 1999), financing that is generally less economical. All these elements, in essence, justify the need to finance investments with short-term or current characteristics, with permanent funds or resources; Likewise, it leads to the analysis of the sufficiency or insufficiency of working capital.
The problem of the sufficiency and insufficiency of Working Capital.
As discussed so far, the maintenance of working capital has implications on risk and profitability, so its levels in terms of sufficiency and insufficiency is of vital analysis.
A fundamental element to take into account with respect to the adequacy of working capital is that it gives the company the ability to conduct its operations on the most economical basis and without financial restrictions and to face emergencies and losses without danger of financial disaster.. Likewise, this sufficiency allows granting favorable credit conditions to clients, operating more efficiently without delays in obtaining materials, services and supplies due to credit difficulties, and supporting periods of depression.
In turn, a sufficient working capital: protects from the adverse effect of a decrease in the values of current assets; makes it possible to pay all obligations on time and take advantage of discounts for prompt payment; it assures a high degree of credit maintenance and provides what is necessary to face emergencies such as strikes, floods and fires, and allows to maintain inventories at a level that satisfactorily serves the needs of clients.
In this sense, it should be noted that the degree to which current assets exceed working capital needs, the business will have excess of it.
Consequently, insufficient working capital is one of the most important diseases of businesses that cannot cover their current liabilities and, according to RD Kennedy (1999), there are some issues that cause it. One of these refers to the obtaining of operating losses, in which an insufficient volume of sales is incurred in relation to the cost to achieve them, due to reduced sales prices due to competition or without a proportionate decrease in the cost of merchandise sold and expenses, due to overspending due to uncollectible accounts receivable, due to increases in expenses not accompanied by a functional increase in sales or income, and due to increases in expenses while decreasing sales or expenses. income.
The insufficiency of working capital can also be caused by excessive losses from non-normal or extraordinary operations, which can cause a reduction in the values of current assets or the creation of a current liability (none of these circumstances can be offset by a favorable change in working capital).
Likewise, the failure of the management to obtain the necessary sources of resources to finance the expansion of the business; the not very conservative dividend policy; the investment of current funds in non-current assets and the non-accumulation of the funds necessary for the settlement of bonds at maturity or for the withdrawal of preferred shares, is another group of causes that generate insufficient working capital.
To the above can be added the existence of a fixed provision for a sinking fund, whose needs are excessive in relation to net income; price increases, thus requiring the investment of more cash to maintain the same physical amount in inventories and fixed assets and to finance sales on credit for the same physical volume of merchandise, having to retain sufficient profits in the business to de this way, finance the higher costs. All of the above add to the causes of insufficient working capital.
Faced with these problems, some of the actions to take into account when there is a working capital deficit that avoid suspension of payments and liquidity problems include:
- reduce collection and inventory times to reduce working capital needs (tending to have raw materials stored by suppliers, reducing the days of the production cycle and stocks of finished products, invoicing and charging customers earlier), negotiate longer payment terms with suppliers, increase own capital or long-term payable, sell fixed assets and decrease short-term payable (O. Amat, 1998).
Taking into account the criteria previously exposed by the different authors, it can be reflected that the correct analysis of working capital consists of the analysis of its components: current assets and current financing in an effective and efficient way, which allows to face the payment commitments in a timely manner. in the short term, having a positive impact on the economic and financial results of the company and society, managing to minimize risk and maximize profitability.
Conclusions
What is exposed in the article shows the analysis of working capital as a fundamental function of financial management, so the studies carried out on its behavior and / or evolution must be based fundamentally on basic elements, namely: the characteristics of the sector where the company operates, current investment and financing policies, the quality of current assets and liabilities, the relationship between growth in sales and current items, cash inflows and disbursements, total risk and profitability of resources.
These elements are essential in the comprehensive study, to draw valid conclusions in the truthful analysis of the behavior of working capital, so that relevant information is obtained in the decision-making process.
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