What is Capital Management?
Capital Management is essentially an accounting strategy with the end goal of sustaining adequate as well as equal levels of working capital and currents assets and liabilities. Capital Management aids a company in meeting its expense responsibilities while at the same time sustaining adequate revenue.
Capital Management is primarily related to financial decisions in the short term. The goal of Capital Management should be to ensure that a company has the ability to satiate both looming operational expenses and short-term debt that is maturing.
The management of working capital involves managing inventories, accounts receivable and payable, and cash.
In essence Capital Management provides companies both short and long term health through the management of capital resources. Done effectively, it allows companies to effectively meet their debt obligations and operating expenses.
Who Uses Capital Management?
Companies large and small in various sectors use capital management systems and nearly all companies using it can benefit from it as it’s an excellent way for them to improve their earnings. The two main aspects of capital management are ratio analysis and the management of working capital’s individual components.
A few key performance ratios of a working capital management system are:
- working capital ratio
- inventory turnover
- collection ratio
When managing capital, a company should have neither redundant working capital nor inadequate working capital. Both excess as well as shortage of working capital situations are not good for any company. Excessive working capital means idle funds which earns no profits for the company.
Here are some of the disadvantages of excess working capital:
1. Excess working capital correlates to idle funds which is essentially non-profitable for the company and will bring about a low return on its investments.
2. Unnecessary purchasing & accumulation of inventories over required level.
3. Excessive debtors and defective credit policy leading to a higher rate of bad debts.
4. Overall inefficiency in the company.
5. Due to the low rate of return on investments, the market value of shares may fall.
Here are some disadvantages of inadequate working capital:
- Inability to meet short-term liabilities in time, resulting in loss of the worthiness of credit and the advantages of economies of scale (e.g.: bulk quantity discounts) are not possible.
- Difficult for the company to implement operating plans while achieving the company’s profit targets.
- The company’s liquidity gets worse, which can lead to increased operating inefficiencies and therefore, low profits.
- Improper utilization of the fixed assets and hence, ROA/ROI falls sharply.
Working capital management then, means the administration of all aspects of current assets (cash, marketable securities, debtors and stock) and current liabilities. The financial manager of the company should determine the levels and composition of current assets and ensure that the right sources are tapped to finance these current assets and that the current liabilities are paid in a timely manner.
Working capital management policies of a company in fact, have a significant impact on the profitability, liquidity and structural health of an organization.
Therefore, working capital management is three-dimensional in nature:
- Dimension I: Formulation of policies regarding profitability, risk and liquidity
- Dimension II: Decisions regarding composition and level of current assets
- Dimension III: Decisions regarding composition and level of current liabilities
If Capital Management is to be done correctly and efficiently, the company’s finance manager should flesh out appropriate policies in respect of each of the components of working capital to ensure higher profitability, proper liquidity, and sound structural strength. To ensure solvency, the company should be very liquid, which correlates to larger current assets holdings. If the company sustains a relatively large investment in current assets, it will have no difficulty in paying the claims of the creditors when they become due and will be able to fill all sales orders and ensure smooth production.
A liquid company faces less risk of insolvency and should generally not experience cash shortages or stock-outs. However, there is cost associated with maintaining a sound liquidity position since a significant amount of the company’s funds will be tied up in current assets, and to the extent this investment is idle, the company’s profitability will suffer.
However, in order to have higher profitability, a company may choose to sacrifice solvency and maintain a relatively low level of current assets. In this case, the company’s profitability will improve as fewer funds are tied up in idle current assets, but its solvency would be threatened and thereby, the company would be exposed to greater risk of cash shortages and stock-outs.