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According to Alvarez, Sensini, and Vazquez (2021), working capital is referred to as capital which is used to finance day-to-day operational activities in a business. In the Financial Accounting context, Working Capital is the difference between the Current Assets (CA) and the Current Liabilities (CL). This is represented by the following formula: CA minus CL = Working Capital (WC).
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According to Amendola, Candila, Sensini, and Storti (2020), the Working Capital may be referred to as the management of the Working Capital Cycle. In this article, a company called ABC will be used as a case study for illustration purposes. For example, if ABC company’s Current Assets are $40,000 and Current Liabilities are $35,000, the Working Capital is equal to $5,000.
This is an indication that ABC Company is Financially Healthy or Financially Sound. However, if the ABC Company’s CA is $10,000 and CL is $12,000, the WC is equal to a minus or negative $2,000, this shows that ABC Company is Financially Unhealthy, not Financially Sound or is insolvent.
It is from this background that Healthy businesses embrace positive Working Capital to remain competitive in this dynamic environment. It is imperative to define solvency and insolvency.
Solvency
Solvency in financial accounting is defined as a situation whereby a company, is able to pay its short-term obligations, now and in the future (Yeo, 2016).
This is a healthy position for ABC Company as it can sustain its current and future obligations due to sufficient cash and cash equivalents which will be used to meet short-term obligations such as wages, salaries, administrative expenses, rent, and unpaid taxes. It is from this backdrop that healthy businesses embrace the management of a positive Working Capital.
Insolvency
Insolvency is a negative financial metric whereby ABC Company is not in a situation to pay its short-term obligations, such as wages, salaries, administrative expenses, rent, and unpaid taxes.
According to Cont, Kotlicki, and Valderrama (2020), insolvency is referred to as a situation whereby a company fails to pay its short-term obligations. The insolvency situation is not favorable, and companies should avoid it at all costs. Therefore, it is imperative to explain the Working Capital Cycle management which should be used by companies to remain in business.
Working capital management
Cash and cash equivalents
The working Capital Cycle is referred to as the management of cash and cash equivalents as this is in the form of a cycle. The cycle starts with the Cash on hand or in the bank account.
The cash on hand is used to purchase cash sales for resale. In addition, if the cash is not sufficient Company ABC may request its suppliers to provide goods and services on credit.
Cash and credit purchases
The cash and credit purchases will be in a form of raw materials and inventory. The Cash and credit purchases are then converted into materials used in the production department.
If ABC purchases goods on credit from its suppliers, in financial accounting language, they are known as Accounts Payables.
Production
At the production stage, the raw materials are processed into finished goods. In this production process, cash is needed to pay for labor, rent and the production equipment and machinery. When production is completed, the goods are stored in the warehouses or dispatched to respective customers.
According to Payne and Bustos (2008), in financial accounting, there are two types of customers as follows: cash customers and credit customers. Cash customers buy goods and services from ABC by cash and credit customers are those customers who buy goods from ABC on a credit basis, and they are referred to as Accounts Receivables. Therefore, it is important for ABC to maintain accounts payables, accounts receivables, and good debt collection.
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Accounts payables
Accounts Payables represent the balances for suppliers for which ABC owes money for the goods and services bought on credit.
It is good cash management to pay the Accounts Payables / Trade Creditors after receiving cash from Accounts Receivables. In some instances, it is good management to pay creditors after 60 days from the date of receiving the goods.
Accounts receivables
Accounts Receivables are known as Trade Debtors, and it is important to collect cash from these customers before the payment of Trade Creditors.
Therefore, in financial accounting, Trade Debtors should pay first within 30 days and Trade Creditors must be paid in 60 days to maintain the cash and cash equivalent.
Debt collection
The cash collected from Trade Debtors will be then deposited into the Current Account. The cycle will then start again when cash is being used to purchase goods and services. Therefore, ABC company should have a strong debt collection team.
Critique of working capital
It is important to maintain a reasonable balance for trade debtors, inventory, and trade creditors. Large amounts of trade debt and inventory will be perceived as money being tied to the trade debt and inventory. The inventory should be recognised into sales so many times in each given period as this is a reflection that inventory is being converted into cash quickly.
Therefore, converting inventory quickly into cash will boost the cash and cash equivalent for an enterprise, hence the business will remain solvent, liquid, and healthy. Therefore, the ABC company should maintain a positive healthy Working Capital (WC), as follows: CA – CL = WK. However, if there is a negative Working Capital (WC), it is sign of being insolvent and unhealthy which may lead to bankruptcy.
Conclusion
It is imperative for any organisation to embrace a positive working capital to remain competitive in this dynamic environment. Moreover, it is important for firms such as ABC to maintain a positive Working Capital to enhance its sustainability and business continuity. A positive Working Capital enhances the solvency of any firm, hence it is imperative for firms to maintain a positive cash and cash equivalent.