Discuss the importance of working capital management and how it relates to the working capital cycle of a small business.

Question

What will be an ideal response?

Answer 1

Working capital management—managing current assets and short-term sources of financing (current liabilities)—is extremely important to most small companies. In fact, no financial management process is more important. Good business opportunities can be irreparably damaged by ineffective management of current assets and short-term liabilities. A firm's working capital cycle is the flow of resources through the company's accounts as part of its day-to-day operations. The steps in a firm's working capital cycle are as follows: Step 1:Purchase or produce inventory for sale, which increases inventory on hand and (a) decreases cash if cash is used to pay for the inventory or (b) increases accounts payable if the inventory is purchased on credit.Step 2:(a) Sell the inventory for cash, which increases cash, or (b) sell the inventory on credit, which increases accounts receivable.Step 3:(a) Pay the accounts payable, which decreases accounts payable and decreases cash. (b) Pay operating expenses and taxes, which decreases cash.Step 4.Collect the accounts receivable when due, which decreases accounts receivable and increases cash.Step 5.Begin the cycle again. Depending on the industry, the working capital cycle may be long or short. Whatever the industry, however, management should be working continuously to shorten the cycle.