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Capital management in finance is important because companies must generate enough cash to meet their short-term needs if they want to remain competitive in today’s economy. Capital management helps companies achieve long-term success through properly balancing current assets with the company’s liquidity position, according to Investopedia.
Types of Capital
Working capital is what companies liquefy to support projects, expansion and investments. Working capital can transform between cash, inventory and account receivables. First, gross working capital refers to the total amount of current assets. The financial difference between current assets and liabilities is referred to as net working capital. Permanent working capital is the minimum amount of financial resources that must always remain invested. This means that a certain amount of cash, stock or account receivables are not accessible. These permanent assets are used by the company to carry out daily business operations and they are generally drawn from long term sources. Variable working capital are flexible funds that are drawn from short-term sources to handle the financial needs as they increase and decrease because of environmental factors.
The Purpose of Capital Management
Working capital management requires clear guidelines and objectives in order to be financially effective. There are two main goals of working capital management: increase profitability and ensure sufficient liquidity is always available. Investment in current assets should only occur if acceptable returns are projected. Company profitability and shareholder wealth maximization are equally important. Liquidity is needed for companies to stay in business, but some choose to retain more cash than is necessary for operational needs to minimize risks. The simultaneous goals of liquidity and profitability conflict with each other because liquid assets provide the lowest returns, but cash stored away will not generate returns. Capital management professionals must ensure a smooth working capital operating cycle for their business to properly function. Minimizing the cost of capital, which is the money spent maintaining the working capital, must be insured.
Capital Management Policies
Working capital management is important, so companies must create and enforce clear policies regarding various working capital components. These policies specify the investment levels of working capital for each operation and the details of how working capital should be used for short-term funds. Working capital policies should cover trade receivables, reporting guidelines and risk and inventory management. Policies are important because management sometimes make poor business decisions. A credit analyst manager that provides credit to customers with questionable financial histories, or an inventory manager who orders unnecessary raw materials are both prime examples. The best working capital policies will establish how to make sound decisions regarding the investment levels, amount needed and the mix of assets.
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Healthy working capital cycles will properly manage the sourcing of raw material. This means that production schedules will never stop because of raw material shortages. Companies that carefully engage in production planning will mitigate risks and avert potential issues. Next, selling goods within normal time frames will reduce inventory and handling costs. Accounts receivables should be collected on time to maintain cash flows. In the end, effective capital management in finance will guarantee a successful company and wealthy shareholders.
