Understanding the relationship between Working Capital Management and Profitability

Working capital management is the most crucial aspect of managing finances which affects both liquidity and profitability of any enterprise. Optimal working capital management stabilises operations and secures the company’s future. The main components of working capital include cash, inventory, receivables, and payables which are the current assets and liabilities of a company.

Working capital is the excess of a company’s current assets over current liabilities payable. It refers to the amount available to meet the day-to-day operational expenditure of a business. The availability of working capital in a company determines its financial health and operational stability.

Some of the factors which affect working capital are:

• Type of business:  Manufacturing industries generally require more working capital than service-based companies.
• Sales volume: Higher the turnover, the higher is the working capital requirement of a company.
• Length of cash cycle: If the invoice to cash cycle is longer, there is a higher working capital requirement.
• Seasonality of business:  If a company is seasonal with peak sales and lean periods working capital requirement fluctuates based on the capital needed to invest in raw material and inventory.

Companies need to prudently manage working capital to achieve the desired balance between liquidity and profitability. Discussed below are a few ways working capital management affects the profitability of a company:

Shortage of working capital

Managing working capital is ensuring that cash is available for day-to-day operational expenses. This means the company needs to have enough liquidity to meet essential expenditures. Inadequate liquidity leads to disruption of business and poor relationships with stakeholders that impact future growth and survival.

Shortage of working capital leads to:

• Delayed payments: Inadequate cash leads to challenges in paying suppliers and utilities on time, the outcome of which is unhappy suppliers. The company resorts to last-minute borrowing of funds at high interest rates, bringing down its profits.
• Missed sales opportunities: When a company has a shortage of working capital, it will miss out on tapping into increased sales during festive periods or other peak seasons. Inability to exploit such opportunities will hinder the company’s long-term growth.
• Employee Dissatisfaction: Inadequate working capital also means delays in payments of salaries and bonuses, leading to dissatisfied employees. Disgruntled employees might leave organisations, causing a massive brain drain or not serve customers in the best possible way leading to lower brand loyalty.

Operating inefficiencies creep into the company when it becomes difficult to meet everyday commitments due to a shortage of working capital. When daily operations are disrupted, the company can’t meet its sales targets and thereby its profits.

Companies can access a flexible working capital line from lenders like Tata Capital to avoid such a shortage. With customised working capital offerings to meet the diverse needs of organisations at different growth stages, Tata Capital helps companies grow with a timely infusion of liquidity to maintain profitability.

Additional Read: Revitalize your financial health by efficiently managing your working capital

Excess working capital

Just like inadequate working capital, excessive working capital also leads to decreased profits. Some ways excess working capital impacts profitability are –

• Idle funds: By sitting on large cash reserves, companies miss out on incremental earnings that could have been earned by investing surplus cash in the right investment opportunities. The shareholders receive a lesser rate of return on their investments as the company is not using the capital optimally.
• Excessive inventory: Higher working capital could also mean money blocked in unsold inventory. Such stocks pose a risk as they could be mishandled, wasted or stolen. Companies with excessive inventory also need to bear high storage costs, which results in unnecessary expenditure and decreased profits.
• High Debtors: Excessive working capital might be the outcome of excessive debtors. Ineffective credit policies could lead to past sales sitting in the balance sheet that pose a high risk of bad debts, further diminishing profits.

Additional Read: Choosing the right working capital solution

Balance is key

Optimum working capital ensures that funds are available for everyday operations while efficiently utilising funds. By balancing income and operational expenses with an adequate cushion as cash reserves, companies can meet payments on time, have sufficient buffer for unprecedented circumstances, and tap into unexpected sales opportunities.

Working Capital Loans from Tata Capital provides great flexibility in meeting the company’s cash flow requirements, which will aid in achieving the company’s goals and generate profit. Adequate working capital ensures that the company has sufficient resources to maintain business operations while honouring its liabilities. Reach out to us for further guidance on working capital management to scale your business steadily and profitably.