Why is Working Capital Management Important for Small Businesses?

By Megha Jain, Content Writer   |  Thursday, April 25, 2024

Why is Working Capital Management Important for Small Businesses?

While most business owners focus on their balance sheet numbers, paying attention to cash flow needs is equally important. Taking charge of working capital management helps keep the company running and expand the business while avoiding financial insolvency.

Working capital is the money a business has for its day-to-day operations, like payroll, raw materials, and other operating costs. A high working capital demonstrates more business stability in the short term. The following sections will discuss the importance of efficient working capital management for a small business.

Impact of Working Capital on a Business

Working capital is the sum of all current assets minus a company's current liabilities. Similar to paying utility bills for an individual, a business also needs money to cover its financial obligations until its customers clear the payments. Unpaid invoices are excellent examples. If a client has a payment term of 90 days, the company cannot use these assets to cover its expenses for the next 90 days.

Working capital or cash flow is one of the most important factors affecting a business’s success or failure. If a company does not have sufficient funds to cover its short-term expenses, it might liquidate its assets and lead to bankruptcy. Therefore, constantly monitoring and managing the working capital is vital for a company. It is a great way to ensure adequate funding for daily business operations.

Importance of Working Capital Management

Working capital management (WCM) has tremendous importance, regardless of the business size and nature. Every company needs a solid strategy to manage working capital, considering numerous scenarios. Apart from keeping the business alive, a solid WCM policy attracts higher profitability. Here are the main reasons why efficient management is essential:

Higher Liquidity: A company with sufficient working capital is highly liquid and can clear its dues even during crises. It prevents a business from facing losses and shutting down, enabling it to survive the situation and quickly restore its regular operating levels.

Better Returns on Employed Capital: An entity's working capital should not be excessively higher than its requirement. A higher capital means the owner's equity finances a larger portion of the assets. A high equity indicates the company needs higher profits to achieve the necessary returns on the employed capital. Efficient WCM management ensures the owner's equity funds only the essential portion of assets, resulting in a higher return on employed capital.

Improved Credit Profile and Solvency: When a company clears its dues on time and still generates revenue, it ensures an efficient operating cycle. Efficiently funding the operating cycle further enhances the credit profile. Conversely, an entity with low operational expenses and failure to repay the dues on time experiences a negative impact on its credit score. It makes borrowing an online Business Loan at the best rates and terms more difficult.

Business Expansion: A company aiming for expansion must maintain a healthy working capital level for finance. It needs funds to purchase orders or provide credit periods to clients and customers. Business scaling and expansion become challenging without adequate working capital.

Higher Profitability: Policies like cash discounts, credit periods for customers, and easy EMIs bear explicit interest costs. An efficient WCM policy reduces interest costs and results in higher profit levels for the company.

Efficient Utilisation of Assets: Efficient WCM with adequate working capital helps a business to utilise its fixed assets more effectively and efficiently. Due to a lack of working capital components like finished goods and raw materials and a lack of funds to purchase them, the business assets must be more active and deliver the expected returns. Even during a period of inactivity, the company must cover certain costs like interest on an online Business Loan, staff salaries, utility bills, etc.

Improved Business Value: An entity with an efficient working capital management policy has a reputation of being highly creditworthy in the market. Its goodwill leads to an increase in its market value and share prices. A better market value leads to greater wealth created for the company owners. Moreover, it can sell its products or services at better prices, giving the company an edge over the competitors.

Uninterrupted Production: Paying creditors or vendors on time is essential for smooth business operations. Failure to make payments on time might put raw material deliveries on hold, resulting in interrupted business production and sales. This eventually harms the company's reputation and causes customers to lose trust.

Better Loan Terms: A company reputed for efficient working capital management and timely dues payment has a higher credit score and creditworthiness. As a result, it can obtain better loan terms from top lenders like Hero FinCorp at attractive interest rates, adequate repayment terms, and favourable terms and conditions.

Tips for Efficient Working Capital Management

After understanding the importance of managing working capital efficiently, one must follow these tips to frame an excellent management plan:

  • A business owner must learn from their losses and mistakes in the past and plan for the future accordingly.
  • Being proactive and staying alert to the changing business environment helps a business adapt accordingly.
  • Mixing business and personal records complicates them, making determining the working capital and profits difficult. Maintaining separate accounts for personal and business transactions is a better strategy.
  • Although timely payments are the core of business operations, forgetting them may land a great business in trouble. Paying all lenders and meeting short-term liabilities on time is essential to maintaining market reputation, liquidity, and relationships with lenders and vendors.
  • Invoicing the debtors and collecting timely payments ensures efficient funds for the business, letting it operate smoothly.
  • Several funding sources may finance a business to help cover its working capital needs. These include Working Capital Loans, Loans Against Property, Bill Discounting, Invoice Discounting, Short-Term Business Loans, etc. One must choose an online Business Loan that best suits their needs and boosts their business.

Working capital management refers to the process of managing a company's working capital. No one can undermine the significance of WCM due to the reasons mentioned above. Its primary objectives are to maintain business liquidity, enhance operational efficiency, decrease interest costs, and increase the business's overall profitability. During financial crunches, apply for a Business Loan online to get the required funding and fill the financial gaps.

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