- Reduction of working capital is a method of financing a business by decreasing its current assets and/or increasing its current liabilities to generate cash flow.
- It involves using the cash generated from reducing current assets or increasing current liabilities to meet short-term financial obligations.
Features of Reduction of Working Capital as a Source of Finance:
- Involves reducing current assets or increasing current liabilities.
- This can be in the form of:
- Delaying payment to suppliers
- Reducing inventory levels
- Negotiating longer payment terms with customers
- Tightening credit policies to reduce accounts receivable
- Selling excess or obsolete assets
- Streamlining operations to reduce costs
- Outsourcing non-core activities to reduce expenses
- Implementing lean manufacturing or just-in-time practices to reduce inventory and improve cash flow.
- Provides short-term financing for the business.
- May result in reduced liquidity for the business.
- Can be a temporary solution to cash flow problems.
- May have an impact on the company’s credit rating.
- May require approval from creditors or investors.
Situations where Reduction of Working Capital may be Appropriate:
- When a company needs to raise funds quickly.
- When a company has excess inventory or accounts receivable.
- When a company has short-term debt that needs to be paid off.
- When a company has a seasonal business and needs to manage cash flow during slow periods.
Benefits of Reduction of Working Capital as a Source of Finance:
- Can be a quick solution to cash flow problems.
- May not require external financing or additional debt.
- Can help to improve a company’s cash conversion cycle.
- Can free up resources for other investments or activities.
Drawbacks of Reduction of Working Capital as a Source of Finance:
- May result in reduced liquidity for the business.
- May impact the company’s credit rating.
- May only be a temporary solution to cash flow problems.
- May require approval from creditors or investors.
- May result in reduced current assets that are needed for day-to-day operations.
- May not be a suitable option for companies that have already reduced working capital to a minimum.