The Effect of Working Capital Management on the Profitability of an Organization ( a Case Study of Sky Bank)
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CONCEPT OF WORKING CAPITAL MANAGEMENT
The concept of working capital became established in 1940’s. Though there were some disagreement as to exact meaning of working capital (Pandy, 1998). The confusion at that time centered on how properly they classified current assets (as one of the main component of working capital, the other one being current liabilities) and that is whether currents assets should be defined as those that will be converted on the short-term being taken as one year.
The confusion is understandable because the identification of current asset and current liabilities traditionally be considered. Useful information assist financial analyst in enterprises financial position criticism against one year rule resulted in the operation cycle to be taken as the basis for classifying current assets. The operating circles point of views or working capital is to emphasizes the ability of the firm to pay it nurturing obligation from the fund generated by current operation which is departure from traditional notion of working capital was primarily concerned with whether or not current asset were immediately realizable and available to pay debt in cash of liquidation.
International Accounting Standard number 12th effective 1st January, 1981, however, recognizes that even when the operating circle approach is used as a general rule, there are instances of the inclusion or exclusion of individual items based on different criteria. Hence, the classification of items, current or non-current in practice is largely based on convention rather than on any one concept. In the financial statement literature therefore, it is defined in two ways. According to the definition, it is difference between current asset and current liabilities. This is commonly referred to as working capital, the other definition is the total of current assets and this is called gross working capital. The above definition emphasized on assts, that is, utilization of resources and ignores both extent and nature of working capital.
Furthermore, (Pandey, 2001) explain the concept of working capital in two days that is the gross working capital and networking capital., Gross working capital: it refers to the firm’s investment in current assets. Current assets are the assets, which can be converted into cash within an accounting year (or operating cycle), while networking capital: refers to the difference between current assets and current liabilities. Current liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year and include creditors (account payable), bills payable and outstanding expenses. Networking capital can be positive or negative i.e. a positive working capital will arise when current asset exceed current liabilities while a negative working capital occurs when current liabilities are in excess of current assets.
However, working capital can be classified in to circulating and non-circulating. The non-circulating working capital does not continuously pass through the stage of business operations. For the circulating working capital passes current in the normal and regular course of firms operations through a sequential series consisting of cash, cost of production, inventories and receivable.
CHARACTERISTICS OF WORKING CAPITAL MANAGEMENT
The proceeding definition highlighted hidden and vital characteristics of working capital that could be of immense importance and help to give understanding of subsequent chapters of this research work.
The components of working capital which are the current assets, have life span leads to high violability in the level of investments are required to finance working capital. During the economic, boom and recession consideration must be given to working assets. Their short-term span coupled with the uncertainty of economy may require management to take a firm stand in the management of working capital. Fluctuation in quantity and worth of working assets are normally experienced.
Furthermore, anticipated labour strives, material shortages, transportation problems, energy curtailment and so forth, all would affect working capital investments. Thus, the short life span coupled with the rapid turnover of working capital stresses its importance in the management or risk and return. The continuous trade off between liquidity and profitability stress the nearness cash characteristics of working capital. Hence, the easy convertibility of assets into cash increases the liquidity position of corporation. An example is when finished goods are sold, it is converted into cash account receivables on collected are transformed into cash. Hence, this component of working capital passes liquidity quality and this constitutes a defense against technical investment.
Nevertheless, investment in current assets and how they are financed have bearing on working capital is affected by sales volume, production and collection policies. Management has to strive hard because of short-term tool of synchronization between demand and supply.
WORKING CAPITAL COMPONENT IN BANKING SECTOR
There is a great difference between the components that made up the working capital in the manufacturing sector which is producer of tangible products compared to that in banking sector, that is, producer of intangible products (financial service). While in a traditional manufacturing sector, the current asset is part of the working capital composes of stock, debtors, cash in hand, cash in bank, prepayment, etc and current liability part composes of creditors accruals, short-term loans and overdraft etc. In the banking sectors, the most recognized component that is missing in the line up of current asset is the “stock”. The component of the current liability is almost the same. Though, in both the current asset and current liability may not be referred to as terms used.
Under a manufacturing set-up this difference may not be unconnected with the fact that manufacturing set up provide goods and that is principal current asset that general current assets. Whereas, in the banking sector it is thus, it renders services to its customer. In view of this serves the principal purpose, stocks serves in a manufacturing sector. Hence, the need for proper and effective cash management in the first place and other components of this working capital in the banking sector can now be listed under two headings:
a) Current assets
- Short-term investment
- Foreign exchange transaction, etc.
b) Current liabilities
i) Fixed deposit, current deposit and other accounts
ii) Taxes payable
iii) Dividend payable
iv) Interest payment
- Bank creditor and overdraft
THE MEANING AND IMPORTANCE OF CASH MANAGEMENT IN THE BANK
To the banking sector, cash is the most important resources of the entire current asset. Cash among other currents is suitable for the smooth and effective operations in this sector. Full operation cannot be achieved. In a bank without that availability of cash as this is its objectives of the trade. Cash is use to pay customer money whenever they require them. It is also use to pay employees for service they tendered, also to pay partly or wholly money borrowed from creditors and used to pay creditors interest. Cash is made up cash in hand and cash in bank.
In this prospective, cash management involves managing the money of the bank in order to attain maximum cash availability and maximum interest as income on any idle funds. The function starts when a customer pays or writes a cheque to pay the bank on the account receivable by the bank.
All activities between this two point fall within the realm of cash management. The banks effort to make customers pay their owing the bank at a certain time falls within account receivable, management on other hand, the bank’s decision about when to pay creditors involves account payable and accrual management.
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