What are working capital sources and working capital management?

Working capital is the operating capital of a business which is used in its day-to-day operations, calculated as the current assets minus the current liabilities. The positive working capital commonly indicates that a company can pay off its short-term liabilities almost immediately.

Sources of working capital are Share Capital, retained profits,  debentures,  long-term loans, and provisions for depreciation are usually considered long-term working capital sources. The sources of short-term working capital include tax provisions, public deposits, Commercial papers, Cash Credit limits availed from the banks, and others. Trade Credit is another important source of short-term working capital involving delayed payment to suppliers which effectively provides an interest-free loan.

An important objective of working capital management is improving profitability without exposing liquidity.

For example, the tendency of some manufacturing units to hold the current assets (stocks and receivables) beyond the requirement of the holding period has financial implications, as more amount of interest is payable on current liabilities for the time taken in converting the current assets into cash. In other words, saving of financial cost of the business in its operations and ensuring that it has sufficient funds to satisfy both maturing short-term liabilities and upcoming operational expenses.

Another important function of working capital management is to appraise the operating and financial performance of an economic activity and determine its efficiency, profitability, liquidity, and solvency. Appraisal of the Current ratio and quick ratio are the two important parameters of working capital.

Current Ratio: This ratio indicates the credit strength of a business by indicating how much of current assets are available for meeting each rupee of liability. The current ratio also shows the solvency and adequacy of working capital in a business. It also gives a fair idea of over-trading. Any rise in the current ratio shows improved credit strength and a fall indicates deteriorating credit strength.  Although, the higher ratio may be good from the point of view of creditors; in the long run very high current ratio may also affect the profitability of the firm.

Quick ratio/Acid test: The objective of the Quick ratio/Acid test is to know the level of liquidity position to pay off all current liabilities including Bank Liabilities. The ratio indicates the extent to which current liabilities could be met without relying upon the sale of stock, which means the size of the liquid assets that can be readily converted into cash about the total liability.

Conclusion: Good working capital management will improve the solvency as well as profitability for an organization