The inventories and trade receivables in proportion of

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The importance of working capital has been examined from
different aspects in previous studies. For instance, a substantial body of
research investigated the impact of optimal inventory management and examined
the best way of managing accounts receivable in order to maximize profitability
and also examined individual components of operating working capital. Recently
Haq et al. (2011) noted that working capital management directly affects the
profitability of a firm. This implies that working capital management is one of
the elementary decisions that a finance manager makes. The objective of working
capital management is to ensure that the firm is able to meet its operating
expenses and also remain in a position to pay short-term obligations.

The mismanagement of working capital may reduce profitability
and lead to a liquidity crisis and, hence affecting the ability of the firm to
continue to operate effectively. Firms manage working capital using three
approaches: conservative, aggressive and moderate. In aggressive approach, firms
having fewer current assets– for example, cash, inventories and trade
receivables in proportion of total assets. This may lead to illiquidity (Van
Horne and Wachowicz, 2004). On the other hand in conservative approach, a firm
tends to use mostly long-term sources of finance for its operations and use
short-term sources in urgent circumstances. A moderate approach trends between
the aggressive and conservative approaches. A moderate approach makes a
distinction between fluctuating current assets and permanent current assets
with the suggestion that short-term sources of finance should be used to
finance fluctuating current assets. Likewise, long-term source of finance
should be used to finance permanent current assets.

Different businesses have different requirement of working
capital, that’s why working capital management policies need to consider the nature
of the company. For instance, food retailers will need to have large
inventories of goods for resale but will have few trade receivables, while manufacturing
firms need to invest heavily in spare parts and components. However, firms may
focus on increasing sales by offering trade credit to their customers but this
may increase the stock turnover, it may lead to problems because some accounts
receivables may take a longer time to be matured while a firm may also be
required to finance its operations through credit when there is an increase in
credit sale and hence an increase in accounts payable. Having sufficient
inventory ensures that a firm does not run out of stock but this may lead to
incurring extra cost of storage and also some inventory getting stolen or going
bad. In addition, apart from tying capital in terms of excess inventories, ,
the credit rating of the firm may be affected if a firm takes a longer time to
pay its creditors and the suppliers may hold back their goods. Therefore it is
important that accounts receivable, accounts payable and inventory turnover are
maintained at a certain level which may be improved by efficient monitoring.

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In this context, working capital management plays a
significant role in the overall corporate strategy of maximizing shareholders’
value. Maximizing shareholders’ value encompasses determining the composition
and sources of short-term finance and the level of current assets (Nwankwo and
Osho, 2010). In addition,  Alshubiri
(2011) notes that firms are likely to react quickly who are efficiently manage
their working capital are. This requires that firms constantly monitor the
level of inventories, accounts receivable and payable.

Categories: Management


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