Working Capital Management as a Tool for Business Survival

The growing population of small businesses and startups, and the increasing rate of ‘crashing out’ or liquidation of such businesses has become an issue of concern in an already harsh national economy. The small businesses in no small measure contribute to the development of the nation’s economy as they not only provide avenues for entrepreneurs to spring up, but they serve as employers of labor; thus reducing the level of unemployment in the economy.

Given the aforementioned benefits, it will thus be important to ensure the sustainability of the small and medium scale enterprises.

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In spite of the fact that SMEs have been regarded as the bulwark for employment generation and technological development in Nigeria, the sector nevertheless has had its own fair share of neglect with concomitant unsavory impacts on the economy. In a seminar titled “Career Crisis and Financial Distress- The Way Out”, the General Manager of Enterprise and Financial Support Company Limited, Mr. Oluseyi Oluboba, identified in his paper the following as the main problems of SMEs, which are however not insurmountable: low level of entrepreneurial skills, poor management practices, constrained access to money and capital markets, low equity participation from the promoters because of insufficient personal savings due to their level of poverty and low return on investment, inadequate equity capital, poor infrastructural facilities, high rate of enterprise mortality, shortages of skilled manpower, multiplicity of regulatory agencies and overbearing operating environment, societal and attitudinal problems, integrity and transparency problems, restricted market access, lack of skills in international trading bureaucracy, lack of access to information given that it is costly at times (Basil, 2005)

The Small Scale and Medium Sized Enterprises (SMEs) have been credited with enormous contribution to the growth of the developed economies of the world. In the same vein, the Information and Communications Technologies (ICT), and particularly the Internet have played their own part in those economies. The SMEs provide the cornerstones on which any country’s economic growth and stability rests. The American economy, the largest economy in the world, depends largely on the success of SMEs for “innovation, productivity, job growth and stability” (SBA Report, 2000).

Small businesses represent more than 99% of all employers, employ 51% of private-sector workers, employ 38% of workers in high-tech occupations, provide about 75% of new jobs of the private sector output and represent 96% of all goods exporters” (Twist, 2000).

There was a dramatic growth in the American economy in 1999 when almost 2.8 million new, private-sector jobs were created. According to the SBA Report (2000), 75 percent of these new jobs were created by the SMEs with the services sector topping the list with about 1 million, followed by manufacturing, finance and insurance. The same story emerges in every other economy. The differences lie in the magnitude of impact and the indices for measuring them.

The rapid transformation of the “Asian Tiger” countries of India, Malaysia, Indonesia, Taiwan and Hong Kong, has also been hailed as proof that SMEs are major catalysts to economic development. Their importance to any economy hinges on their ability to stimulate indigenous entrepreneurship, to provide employment to a greater number of people; to mobilize and utilize domestic savings and raw materials, to provide intermediate raw materials or semi-processed products to large-scale enterprises, and to curtail rural-urban migration. Of equal strategic importance is also the role of the SMEs in other developing countries like Nigeria. With a Gross National Product (GNP) of some $41.2 billion and a World Bank estimated population of 126.9 million, Nigeria is one of the largest economies in Africa (World Bank Report, 2000). This being the case, the economic success or failure of Nigeria can affect not only the country but the whole of sub Sahara Africa. This is why any effort geared towards understanding how the SMEs make use of emerging technologies in improving their products and services which ultimately reflect on their growth potential is worthwhile.

A study conducted in Nigeria by the Federal Office of Statistics shows that over 97% of all businesses in Nigeria employ less than 100 employees. This therefore means that about 97% of all businesses in Nigeria are SMEs (Ariyo, 2000). The Federal Government of Nigeria initiated and actualized some policy measures, like the setting up of Small and Medium Industries Equity Investment Scheme (SMIEIS), in the expectation that improved funding would facilitate the achievement of higher economic growth.

Working Capital (abbreviated WC) in the simplest of terms refers to the financial input a business or organization requires for its day to day running and maintenance to ensure sustainability.

Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is calculated as current assets minus current liabilities. It is a derivation of working capital that is commonly used in valuation techniques such as DCFs (Discounted cash flows). If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.

The existence, survival, growth and stability of any corporate body is highly dependent on the efficiency and effectiveness of its management. This is measured by the ability of the organization’s management to combine all the necessary material for optimal and efficient actualization of their set objectives within the stipulated time. In any organization, cash forms the life wire, which determines to a large-extent, its growth, existence and survival among other competing firms. As a result, it becomes imperative for the management of any organization to give a close attention to the management of working capital if they want to stand the test of time. The management decides the best proportion of its investment on both fixed and current assets and finally her liability level to enable improvement and correction of imbalances in the liquidity position of the firm. Most organizations believe in profitability, but it is generally accepted that liquidity is more important for survival and growth. The reason behind this premise is that most organizations make profit but do not posses enough or adequate, liquid asset to off-set current obligations. However, this inability to make payment at when due may definitely have serious consequences on the organization financial growth. Weak liquidity makes it unsafe and unsound for the survival of the company but all it takes is efficient and effective management Nwankwo (2005).

A company can be endowed with assets and profitability but short of liquidity if its assets cannot readily be converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash (Wikipedia, 2011).

The working capital meets the short-term financial requirements of a business enterprise. It is a trading capital, not retained in the business in a particular form for longer than a year. The money invested in it changes form and substance during the normal course of business operations. The need for maintaining an adequate working capital can hardly be questioned. Just as circulation of blood is very necessary in the human body to maintain life, the flow of funds is very necessary to maintain business. If it becomes weak, the business can hardly prosper and survive. Working capital starvation is generally credited as a major cause if not the major cause of small business failure in many developed and developing countries (Rafuse, 1996).

The success of a firm depends ultimately, on its ability to generate cash receipts in excess of disbursements. The cash flow problems of many small businesses are exacerbated by poor financial management and in particular the lack of planning cash requirements (Jarvis et al, 1996).

Net working capital on the other hand, is the difference between a business’ current assets and its current liabilities. Working capital policy, then, refers to decisions related to types and amounts of current assets and the means of financing them. These decisions will necessarily involve:

• The management of cash and inventories

• Credit policy and collection of accounts receivables

• Short-term borrowing and other financing opportunities such as trade credit

• Inventory financing

• Receivables financing

Working capital management is primarily concerned with the day-to-day operations rather than long-term business decisions. For example, plans for introducing new products to the market and plans for obtaining the facilities and equipment necessary to produce them are strategic in nature, as are the long-term financing needs of the firm. On the other hand, working capital management policies target short-term concerns such as the:

• Availability of raw material and inventories

• Continuous operation of the production line

• Granting credit to customers and collecting past-due accounts

• Taking advantage of credit purchases and the discounts for early payments

• The management of the cash account

These factors help promote smooth operation of the business on a day-to-day basis.

Since the average firm has about 40 percent of its capital tied up in current assets, decisions regarding working capital greatly impact business success. This is especially true for smaller businesses which often minimize their investment in fixed assets by leasing rather than buying, but which cannot avoid investing in inventories, cash and receivables. Further, small businesses tend to have a limited number of financing opportunities and less access to capital markets. This requires them to rely heavily on short-term credit such as accounts payable, bank loans and credit secured by inventories and/or accounts receivable. The use of any of these financing sources influences working capital by increasing current liabilities Deloof (2003).

Decisions relating to working capital and short term financing are referred to as working capital management. These involve managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of working capital management is to ensure that the firm is able to continue its operations and that it has sufficient cash flow to satisfy both maturing short-term debt and upcoming operational expenses Owolabi, (2005).

Working capital management (WCM) is of particular importance to the small business. With limited access to the long-term capital markets, these firms tend to rely more heavily on owner financing, trade credit and short-term bank loans to finance their needed investment in cash, accounts receivable and inventory (Chittenden et al, 1998; Saccurato, 1994). However, the failure rate among small businesses is very high compared to that of large businesses. Studies in the UK and the US have shown that weak financial management – particularly poor working capital management and inadequate long-term financing – is a primary cause of failure among small businesses (Berryman, 1983; Dunn and Cheatham, 1993). The success factors or impediments that contribute to success or failure are categorized as internal and external factors. The factors categorized as external include financing (such as the availability of attractive financing), economic conditions, competition, government regulations, technology and environmental factors. While the internal factors are managerial skills, workforce, accounting systems and financial management practices.

Some research studies have been undertaken on the working capital management practices of both large and small firms in India, UK, US and Belgium using either a survey based approach (Burns and Walker, 1991; Peel and Wilson, 1996) to identify the push factors for firms to adopt good working capital practices or econometric analysis to investigate the association between WCM and profitability (Shin and Soenen, 1998; Anand, 2001; Deloof, 2003).

A firm is required to maintain a balance between liquidity and profitability while conducting its day to day operations. Liquidity is a precondition to ensure that firms are able to meet its short-term obligations and its continued flow can be guaranteed from a profitable venture. The importance of cash as an indicator of continuing financial health should not be surprising in view of its crucial role within the business. This requires that business must be run both efficiently and profitably. In the process, an asset-liability mismatch may occur which may increase firm’s profitability in the short run but at a risk of its insolvency. On the other hand, too much focus on liquidity will be at the expense of profitability and it is common to find finance textbooks (Gitman, 1984 and Bhattacharya, 2001) begin their working capital sections with a discussion of the risk and return tradeoffs inherent in alternative working capital policies. Thus, the manager of a business entity is in a dilemma of achieving desired tradeoff between liquidity and profitability in order to maximize the value of a firm.

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