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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.

Calculation:

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. 

Liquidity Cycle

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.

Credit Sales

Customers (Debtors) Pay up

Capital injected into a big firm

Purchase of Materials

Produced goods

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)

suppliers

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.

Bank

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

Missed opportunities

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:

Internal causes

Production delays and interruption that do not make the finished good reach end users

Industrial strikes

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.

External Causes

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;

Prompt Invoicing

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

STOCK MANAGEMENT

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

CASH MANAGEMENT

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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