Challenges Encountered in Managing Working Capital and the Solutions: Analytical Essay

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Introduction

[bookmark: _Toc23693773][bookmark: _Toc23694080]Working capital management is important because of its effects on the firm’s profitability and risk, consequently its value. Specifically, working capital investment involves a trade-off between profitability and risk. Some of organizations are still focused to enhance the financial long-term decision traditionally, instead of investment that firms in the short-term assets (Teruel & Solano, 2007). Some of the factors in the working capital are the type of source of finance own by firm. To create the maximum profit, the organization needs to apply the effective working capital management into all decisions making processes. This essay would elaborate all the factors of working capital management and the risk-return of it. Furthermore, the recommendation to the firm base on the advantages and disadvantages of sources of finance.

Working capital management

Working capital management in an organization relies heavily on the selection of the source of finance used. Working capital is the assets that to be use by the organization to carry out its business activity, however the rotation not more than 1 year (Cristiani, et al., 2019). The working capital must be managed effectively that could be determined the adequate financial resources for organization’s business and avoid issues that may incur substantial costs for the organization. One of the effective ways is manage the current assets and debt smoothly so that the organization gets enough net working capital and guarantees the level of liquidity of its organization. Through the utilization of working capital owned by the organization has a purpose to obtain an optimal profit, in result the organization could maintain the level of profitability.

In addition, working capital is current assets minus current liabilities, where the current assets including cash, investments, prepaid expenses, account receivable, and inventory. Then current liabilities including taxes payable (sales, payroll, income), interest payable, bank account overdrafts, accrued expenses, and customer deposits. In order to choose the source of finance that most suitable base on the condition or project, a financial manager should be considering thorough characteristic of each source and the costs of it.

Source of Finance

Every organization established should have a goal to maximize the wealth of their owners. One of the important factors to achieve its goal is the role of financial managers in managing funds of its organization. Management source of finance includes the way that financial managers obtain efficient sources of funds and allocate them or invest it effectively, with optimal management in terms of funding and investment, the organization’s goal to maximize the wealth of the organization’s owners can be achieved (Ida, 2010). It could be mean, source of finance plays the strong role in the organization to achieve its goal, its included equity, debt, debentures, retained earnings, term loans, etc. this area that the most explorable but also the toughest part to running a business in the same time. According to (e-Managing Finance, 2019), sources of finance can be categorized into three part; based on the time period, basis of ownership and control, and basis of source of generation. However, this essay only elaborate the source of finance base on the time period.

[image: Hasil gambar untuk source of finance chart]

Figure 1/Source of finance, source: e-Managing Finance

Use of source of finance depends on the organization’s needs whether it’s the short project, medium, or maintaining on the wide scale. Source of short-term financing typically have a short period of time and use not exceed 1 year. Moreover, it’s involve a small amount of funds relatively, and usually used to finance working capital needs, daily operational costs of the business such as procurement of cash, inventory, the purchase of equipment, payment of salaries for employees, financing of trade receivables, rent payments, and other operational costs. The examples of short-term finance include trade credit, short-term bank loans, facilities overdraft, line of credit, and commercial paper. Medium-terms finance means financing over a period of 3 into5 years when the long-term capital is not available. The sources in medium-term usually loans with a repayment to the financial institution, government, or banks. It would be great option for start-up business which the loan is set repayment time frame and predictable (Priyanka Prakash, 2019). On the other hand, long-term finance generally takes more than 5 years and involves large amount of funds. Due to its long-term nature, usually its used to invest in a big project such as the construction of new factories, the purchase or acquisition of other business, purchased fix assets as machinery, land, vehicles, factories, etc. The sources of long-term finance might be from debt or from its own capital of the owners (Team, 2019).

Effective Working Capital Management

A healthy financial business may be determined with sufficient cash in hand and consistent revenue to take care of all liability obligations, without have more debt. Monitoring the current assets and liabilities to figure the level of liquidity available in the business become a key. In this case, when the business faced with less residual assets, a strategy of processing the source of finance effectively is needed. The effectiveness of working capital management in a business operation include the followings

1. Operational Efficiency

Efficient working capital management will increase the efficiency in the operational process in daily basis as well. In the same time, it would help to maintain the business earnings and profitability. From that characteristic, it can be identified that a firm can take advantage from short-term finance if necessary. If the business faced insufficient net working capital to purchase the obligation, the trade credit can be a solution. Trade credit usually provide by the supplier or other firms. In this transaction, the firm as a debtor has the obligation to pay back within the certain date made by a creditor and the maximum date of pay back after the transaction occurs. The creditor not provide finance in cash, but in form of facilitation of goods. The relation here only made by the mutual trust between supplier and the organization, so there is no require collateral in the form of assets from the buyer, however the creditor still can monitor from a track record.

On the other hand, effective working capital management help to ensure the production process not face any kind of interruptions. The supply of raw material and other goods to the business will be consistent, contributing to acquisition of economies of scale in the business and thus achieving long-term cost efficiency.

2. Improve Cash Flow

The other importance of effective working capital management in a business also help to improve cash flow through the assessment process. Khoshbakht (Morgan, 2015) argued, all levels in the organization should be educated to understand the meaning of effective working capital, the scope and scale of imminent changes as well as their areas of responsibility. Performance benchmarking to evaluate working capital performance and also growth of its own business must be considered also from its shareholders to concern into these metrics. The factor is because each types of business may face the changes of economic demand and supply. Make a smart inventory management decision may be a key as well. In a small business, a firm have to the right amount of inventory to satisfy sales orders without spend much money unnecessary.

Operating liquidity has always been crucial to long-term financial health. Therefore, external finance sources are limited, and attempts are made to cash the exchange bills in order to fulfil the business’s liquidity requirements. This will make the best allocation of resources so that successful cash management can lead to an increase in the availability of working capital needed to meet the business’ everyday obligations.

3. Development of Favourable Financing Conditions

With all fulfilled liquidity positions and working capital needs, there will be a range of financial institutions that will be willing to finance the firm in order to bear with the favourable finance conditions. A business with good relations with suppliers and creditors will also be able to secure payment discounts and interest rate concessions, that will be easier for the company to prepare for more growth and developing for the next projects. Furthermore, effective working capital management help to prepare to face crisis or depression condition in the business market. It would contribute towards regular movement of funds to business process to that changes of demand can be met.

4. Create Value and Increase Profitability

In the term of small and medium-sized business, the firm can create value by reducing their inventories and the number of days for which their accounts are outstanding. Moreover, shortening the cash conversion cycle also improves the firm profitability. The size of inventory directly affects working capital and its management, so inventory must control carefully (Nia, et al., 2012).

5. Arrangements In Multinational Business

On the other hand, the limited access to required information in the multinational organization may lead the issues to managing its working capital in its parent company. For example as Coca-Cola company, they expand the business to all countries around the world, then they need a proper strategy to arrange a huge amount of money to achieve effective working capital management. However, because of the demographic issue, sometimes the funds prove more than required and other times may lower than required. Therefore a firm need to make the right estimates to have unlimited access information to all branches they have, in order to make a correct and fair estimates about working capital that is required for the business. Therefore, the right amount can be made to supplied, not more or less than that.

Risk and return trade-off

The purpose of working capital management is to achieve a balance between profitability and risk. Every investment decision inherent with its risk, though its scale differs depend on the instrument. Otherwise, return might be the most needed aspect in the business. In order to increase the possibility of higher return, investors need to increase the risk taken. The firm’s movement tend to maximize profitability with accept high risk will reduce the level of organization liquidity. Otherwise, a firm that tend to maximize its liquidity will reduce the firm’s profitability potential. It happens because if the firm wants to maximize profitability, it will reduce the current assets, because current assets produce low returns, however if a firm increasing fixed assets which provide high returns, the consequence is reducing liquidity. Conversely, if the firm wants to maximize liquidity, it will increase current assets, but the rate of return will be low so that profitability is also low. However, if the firm have greater sales with a soft credit policy, it can extend the cash cycle. Thus, the longer cash conversion cycle, the higher profitability can achieve. This is contrary to the traditional view that the longer conversion cycle, the lower profitability can achieve by a firm.

To maximize shareholders wealth, there are 3 financial decisions that must be made;

a. Investment decisions
b. Funding decisions
c. Working capital decisions

In working capital decisions policy, there is a trade off between risk and return. A proper strategy must be developed in the business in order to allocate the funds in proper way. If the firm allocating the fund through external sources as financial institutions or creditor, it may lead earn lower profits. It because lesser risks are taken will impact to the opportunity of development and growth as well. Therefor it is better to find a feasible level in asset or cash allocation process in order to increase the ability of its business to fulfil short-term obligations and achieve long term targets of sustenance, growth and development of business (Ermawati, 2011).

Challenges encountered in managing working capital and the solutions

1. Difficulty in medium-low sized business

[bookmark: _Hlk23689222]Political and economic uncertainty continuous give a direct impact to a crisis finance in ab business. This also has impact on the payment of capital in productivity in a firm, cuts employee’s salaries, and also tightening organization expenses. Most large and medium-sized companies downwards rely on loans to bank, they may be in trouble to repay with a huge interest amount. According to Perkin (2012), the credit requirements and availability for middle to lower companies are more difficult then bring greater constraints due to the unstable amount of income or revenue of it compared to the mature business.

2. Diverse Shareholders

The other challenges when a firm prevent to lend the capital from bank, and come up with different shareholders. It may be the best solution at the beginning in order to prevent the huge interest amount from bank loans in the long-term finance. However, usually different perspectives from diverse stakeholders may led inefficient use of funds.

3. Prescriptive analytic

To start a business, it is certainly necessary to have a procurement process in order to now the estimated amount of the right inventory and also the amount of working capital for basic needs that are bound in raw materials. By evaluating millions of scenario outcomes, prescriptive analytics will interpreting information to deliver the best course of action that the firm can take to defined their objectives (Logic, 2018). Subsequently , the firm need a formal structure to increase its working capital, means that the analysis that has been done previously must be allocated in accordance with the estimate of the funds will increase the working capital. Without a formal structure, it will cause unclear funds in the business, inn result in increased use of working capital uncertainty. This waste the using of incompetent working capital in the future. On the other hand, the firm can apply root and branch approach to keep on the key operational and implement a robust supporting system of infrastructure which include aligned incentives, focus metrics and strong management policies. In this scenario, the key enablers would be the implementation of lean production system and efficient supply chain management that will help to reduce costs and make more funds available as working capital. Furthermore, audit and compensation changes with consumers and distributors would help to balance current assets and current liabilities (Arun & Kamath, 2015).

Bibliography

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Nia, N. M., Alouj, H. A., Gezelbash, A. & Amiri, S. M. S., 2012. An Analytical Review of the Effect of Working Capital Development on Financial Performance Measures. American Journal of Scientific Research, 1(77), pp. 110-122.
Priyanka Prakash, J. (2019). Medium Term Loans: Advantages and Disadvantages. [online] Fundera Ledger. Available at: https://www.fundera.com/blog/medium-term-loans-advantages-and-disadvantages [Accessed 27 Oct. 2019].
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