Assessing Your Working Capital: Common Mistakes to be Avoided

In the financial world, there is an old saying, ‘the color of the money is the same; however, its usage differs.’

Money can be used for different purposes by an organization. For instance, a business can use funds for its regular operations, as well as for expansion. Depending upon the objective and the usage of money, a company can borrow or invest.

A business requires funds for the following purposes:

• Acquisition of assets like plant or machinery, land & building, office equipment, research, and development – These assets are also referred to as capital goods as they are used to generate products or deliver services. These assets are long term in nature as they are utilized for a large number of years.
• Regular operations of the company – Certain expenses are incurred regularly to run any business. These expenses are in the form of buying inventory (raw material), paying salaries of team members, marketing, local transport and conveyance, electricity, rent, interest on borrowings, staff welfare, statutory dues, certification, and compliances.

The funds required for the acquisition of assets are called capital investments or long term funds. On the other hand, the funds needed for regular operations of the business are called working capital funds.

“A business that deploys money from regular operations towards expansion will face a cash crunch situation leading to survival problems. Whenever short term funds are used for long term purposes, liquidity problems arise, resulting in stress in regular operations.”

Sources of financing working capital:

The principal source of financing working capital is through the collection of sales proceeds from buyers. Businesses offer credit periods to their buyers (depending on credit policies or industry practices). This credit period decides the cash working capital requirement of the company. Thus the assessment of cash working capital is a combination of monthly outflow under various heads and time gaps in collections from buyers. Practical evaluation of cash working capital requirement for a business and its management ensures smooth working for a company as well as its continued growth.

Common reasons for the working capital mismatch:

1. The assessment of working capital is not in place. Often, an organization makes investments in the procurement of new machines and setting up of production capacities. However, it doesn’t plan to spend money on supporting the operations of the business (in terms of working capital).
2. Utilizing working capital funds for purchasing capital assets or fixed assets.
3. There is no credit policy for customers.
4. A higher credit period is offered to the client/ customer in comparison to the prevalent policy.
5. There aren’t any provisions for expenses like marketing, gratuity, and staff welfare, and as per requirement, funds allocated for regular operations are utilized.
6. There is a delay in the actual collection of funds from customers or buyers.
7. There is no segment-wise assessment of working capital. One segment of the business is supporting another segment, thereby bringing overall stress in operations.

Thus while plant, machinery, and other fixed assets are the limbs of an organization, working capital is the backbone.

If you’re interested in the tool or learning more about the concept, feel free to reach me at akshay@skc.world.

Also read – Why Are We Unable to Execute Our Business Plan?