The Importance of Establishing Policies for the Control of Working Capital Essay Sample
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Introduction of TOPIC
Good management of the working capital is key to the profitability of the business entity and general liquidity of the firm. This paper is an attempt to underscore the importance of instituting sound management of working capital to ensure the success of the business. The working capital is needed for the purpose of making sure that the stocks are paid for and that all amount of credit extended to customers is covered effectively. This capital consists of items that are comprised in the short term assets list (PlanWare 2009). These include stock, liquid cash, debtors. Creditors are subtracted from the result of the sum of the mentioned items.
The above list of items that comprise the working capita can be looked at in terms of two major things. First, we realize that current assets are an essential part of the working capital but it is important that the same be looked with respect to the level of current liabilities. Adequate cash flow is important to ensure that the business operation is not interrupted and this is irrespective of the size of the business entity. Any business that has liabilities must settle the liabilities using cash not profits (PlanWare 2009). Proper management of the working capital is important to guarantee a proper balance between the current liabilities and the cash that is available to pay off the liabilities.
The main objective of properly managing the working capital i
s therefore to make sure that the business has adequate cash for the following tasks or functions of
- The day-to-day cash flow needs of the business are met
- For payment of salaries and settling of wages whenever they fall due
- For paying for the supply of goods and payment of creditors
- Payment of taxes and dividends (those who provide the capital need to be paid as well as the taxes)
- To ensure that there is no interruption in the operation hence guarantee long term survival of the business
If the working capital is not well managed, it can lead the business into falling inn the problem of over-capitalization which would imply that there is under-utilization of the available resources that ultimately leads to low or poor returns. The other problem that can easily sprout from poor management of working capital is overtrading where the business entity attempts to uphold a higher level of sales that cannot be sustained by the available working capital (Dunn 2003). Additionally, the business might also engage in offering credit extension which would imply that if the business is one that upholds overtrading and search for higher sales, it might easily translate into escalated debtors and creditors. This can lead to cash starvation in the long run.
In order for the business to maintain good control of its working capital, it must focus the control no the main items or elements of the working capital. Therefore, the debtors element, the credit element must all be tracked to ensure that there are set terms which are adhered to. Effective policies must be instituted and credit limits established. With respect to the credit offer, the business must seek bank references prior to giving credit to new customer. Procedures should include credit checking on regular basis (Dunn 2003). Lastly, control levels should be established to help in achieving of a systematized management of the working capital and this must encompass the available working capital as well its cost and all other production and consumption requirements. There are many other factors which should be considered and they must be pinpointed. In conclusion, it is evident that proper management of the working capital is an essential aspect of a profitable business.
Dunn P., (2003) “Working Capital Control” Accessed Online from URL: http://www.accountancy.com.pk/articles_students.asp?id=86
Planware Organization (2009) “Business Planning Papers: Managing Working Capital” Accessed Online 9:24 AM 5/22/2010 from URL: http://www.planware.org/workingcapital.htm