Maintaining optimum levels of working capital in an organisation is essential to meet its operational expenses, which ultimately helps achieve the company’s goal and generate profits.
Introduction to working capital terms
Working capital is the amount available with an organisation to meet its day to day obligations. It is the excess of the company’s current assets over its current liabilities. Here are a few terms frequently associated with working capital:
- Gross working capital: Gross working capital is the total existing assets of the company and includes liquid assets like cash and cash equivalents, inventory, short-term investments and accounts receivables
- Net working capital: Net working capital is the difference between the company’s current assets and current liabilities.
- Working capital management: Working capital management is a business plan to ensure that a company effectively uses its current assets and current liabilities to run its business operations. It ensures sufficient cash flow to meet all its short term obligations.
- Working capital policy: It is a policy implemented by a company to ensure that its current assets and current liabilities are in sync with each other.
Introduction to profitability and profitability ratios
The final objective of any business is to generate profits. This is what the shareholders invest for, the management plans for, and the employees work for. Profit is an output measure. If two companies are generating the same profit, it does not mean that they are equally profitable. Just looking at the output numbers and not the input results in the wrong conclusion about profitability. Thus, profit is often seen in various inputs such as equity, capital and assets. This comparison will give you a clearer picture of how a company performs for each input employed in the organisation and its profitability.
In simple words, we can say that profitability is a measure of profits generated by a business measured in percentage, such as percentage of investments, percentage of assets, etc.
Here are a few of the profitability ratios commonly used:
- Return on Equity (ROE): It measures the company’s profits against the investments made by the shareholder.
ROE= (Earnings available for shareholders/Shareholders equity)*100
- Return on total assets (ROA): It measures how efficiently a company uses its assets to generate profits.
ROA= (Earnings available for shareholders/ Total Assets)*100
- Gross operating profit: It measures how efficiently a company uses its operating assets.
GP= (Sales- Cost of goods sold)/(Total Asset- Financial Assets)
- Net profit ratio: It calculates profit margin after deducting operating, administrative and financial expenses.
NP=(Earnings available for shareholders/Net sales)*100
What happens to profitability when there is excess working capital?
Excess working capital results in reduced profits. Some of the reasons are stated below:
- Excess working capital indicates idle funds that the company is not utilising and thus are not earning any profits for the business. The shareholders may receive less rate of return due to missing out on the right investment opportunities.
- It may also result in unnecessary higher purchasing and higher accumulation of inventories, thus increasing the chances of theft and losses. It also results in unnecessary procurement expenses and high storage costs.
- It may also result in defective credit policies, causing past sales to sit on the balance sheet. Thus, increasing the chances of bad debts.
What happens to profitability when there is a shortage of working capital?
Shortage of working capital leads to:
- Loss of potential sale opportunities: Lack of working capital availability makes day to day operations difficult. It prevents procurement of new inventory from meeting new orders resulting in a loss of business. This could hamper the company’s reputation in the long run.
- Delayed payments: Shortage of funds leads to a delay in payment to suppliers. This hampers the relationships with the suppliers. The company may need to borrow funds at the last minute to make the payment to the suppliers. This last-minute funding may cost it a higher interest rate and, thereby, a reduction in profits.
- Stress on relationships with supply chain partners: A shortage in working capital leads to delayed payments, which leads to a strained relationship with the company’s supply chain partners.
- Production Delays: It may even lead to existing production lines not being utilised to the fullest, resulting in the non-fulfilment of existing orders.
Thus, a shortage of working capital results in operational deficiencies, which impacts the organisation’s profits.