Shortage of working capital its effect on Business
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Published: Mon, 5 Dec 2016
Working capital is defined as the operating liquidity available to a business, organisation or any other business entity. It is also part of a company’s operating capital. A business is said to be liquidated when its current asset are more than its current liabilities, but it would have a working capital deficiency when its current liabilities are more less the current assets.
Net Working Capital = Current assets – Current liabilities.
To ensure that the a firm is able to continue its operation and that there is sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses, working capital should be well managed.
Working Capital Management
This is a strategy of maintaining proficient levels of both aspects of working capital, current assets and current liabilities, in deference to one another. Working capital management guarantees that a company has adequate cash flow in order to meet its short-term debt duty and operating expenses.
Managing working capital is all about ensuring that cash available for business (day-to-day) use is sufficient to meet cash requirements at any given time. This means having enough liquidity.
The management of working capital is a continuous process, such that when a business takes off production, it takes time to generate income. Money to pay for stock and other running costs will need to be found from the initial capital invested in the business. As the business cycle continues, income from customers will be available to offset expenditure.
Sufficient funds are needed to pay for additional expenditure until the revenue revives. This continuous process is known as Liquidity Cycle.
Customers (Debtors) Pay up
Capital injected into a big firm
Purchase of Materials
Purposes of working capital management
To ensure that a business firm has enough finance to meet short-term financial needs
To keep cash moving rapidly through the cycle, so that there is enough funds to make future orders
Effects of shortage of working capital
Insufficient working capital is the commonest cause of business failure and liquidity. Many liquidity problems are a result of the firm not setting aside sufficient more for working capital (resulting to a hand-to-mouth)
A firm with too little working capital will struggle to pay its bills on time because it has no spare cash and hence resort to delaying payments which also affects suppliers. It may need to borrow more money to pay supplier at high interest charge.
High additional cost of interest charges from banks are mostly associated to borrowed funds. However, loan providers also find out and want to be sure or assured that their borrowers are efficiently managing their working capital problems before loans are granted
A firm with shortage of working capital will miss many profit generating opportunities ranging from inability to exploit profitable investment opportunities to inability to buy supplies in bulk.
Restricted present and future development or growth
Working capital shortage will hinder the present and future growth and expansion of a business and will make a firm unable to complete with its dominant competitors in a competitive business environment
Causes of working capital shortage
There are two places where the cause of the shortages of working capital could be identified, and these are the Internal and external. These areas are addressed as follows:
Production delays and interruption that do not make the finished good reach end users
Marketing problems which are provoked by low demand of a product and longer credit terms aimed at shifting unsold stocks
Managerial problems due to poor stock management or production management that can result to additional costs.
Changes to economic climate such as inflation, taxation, interest rate, recession
Demand decrease (fall) caused by changes in taste, fashion etc
Unexpected non-payment by customers resulting to bad debt.
Working capital control measures
To maintain a good liquidity ratio, a firm should effectively/efficiently manage the elements of its working capital such as; debtors, cash, stocks, creditors etc. The following are measures taken to manage a firm’s working capital and also to avoid insufficient or shortage in the capital:
TRADE DEBTORS MANAGEMENT
Establish a credit policy in relation to normal credit periods and overall credit control
Establish a policy on individual credit (oblique) limit.
Debt collection management such as;
Offer discount to clients who pay on time
Issue monthly statement to debtors(as reminder)
Institute an effective debt collection and control system
Collect overdue debt
TRADE CREDITORS MANAGEMENT
Increase the range of goods and services bought on credit i.e. have a good credit rating
Don’t over extend the period of time taken to pay debt
Collecting payments efficiently by increasing the portion of cash customers
Ensure an efficient production process
Minimising stock levels of work in progress
Ensure goods are delivered promptly
Minimising stocks of finished
Minimising stock losses
Efficient inventory control
Use of cash-flow forecast
Plan for moments where there will be too little cash to avoid liquidity crisis
Cash planning and budgeting
Cash flow management
Accelerate fund movement among banks
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