Working capital management vs profits: Why knowing and managing relation between two is critical for MSMEs

August 27, 2019 7:50 PM

Working capital management is all about managing current assets vs current liabilities. The more liquid a firm’s current assets (cash, prepaid expenses, inventory and account receivables), the better it can manage routine operations.

Banks and formal financing channels remain the first-choice lenders for MSMEs.

By R Narayan

A significant hurdle to the MSME sector is the timely influx of adequate finance or working capital that enables the day-to-day running of business operations by allowing MSMEs to make short-term transactions. Running a small business requires meeting inventory requirements and managing accounts receivables and payables not to mention manage capacity utilisation. Naturally, the lack of working capital can leave a business owner swimming against the tide.

Banks and formal financing channels remain the first-choice lenders for MSMEs, but excessive paperwork, disbursal delays, and stringent collateral requirements lead to missed business opportunities for MSMEs.

Working Capital Management – Present and Real Concern For SMEs 

Working capital management is all about managing current assets vs current liabilities. The more liquid a firm’s current assets (cash, prepaid expenses, inventory and account receivables), the better it can manage routine operations. Greater cash availability implies that MSMEs can quickly pay off creditors and claim supplier discounts, repay interest charges, and meet other current liabilities. Lack of working capital may lure MSMEs to use long term funds to meet short term liabilities which may result in a mismatch of assets and liabilities- thus resulting in a vicious cycle for MSMEs, one which is difficult to break. 

Working capital management affects the acquisition of customers and also impacts long-term capital and stability. Thus, a firm’s profitability, or rate of return, is affected by imbalances in the working capital, which can be used for three kinds of financial activities – speculation (investing for growth), precaution (securing the future) and transaction (day-to-day operations). A balanced working capital ratio is vital for operational success. 

Over-investing in working capital plummets profitability as surplus funds can be allocated elsewhere. However, insufficient working capital leads to financial insolvency and inadequate funds. An MSME must adopt an aggressive or conservative approach to working capital management which also gravely affects capacity utilization of an enterprise. Good working capital management will result in higher capacity utilization which not only improves the fortunes of the industry owners but also help improve job creation. On the other hand, working capital issues lead to poor capacity utilization, tax hurdles, disrupts planning, control, and operations of inventory, debt repayment, and salary payments. This also poses a huge challenge in attracting investments, thus halting growth. Holding an inappropriate balance of current assets vs current liabilities can have far-reaching business impact. 

Long operating cycles and billing on actuals makes it difficult for small businesses to meet immediate financial obligations. Working capital balances thus function as an indicator of financial health and operational capabilities. And as a corollary, good working capital management will not only result in profitability since it eases the pressure on the business to opt for unviable propositions but also minimizes NPAs and enhances creditworthiness in the market. 

 The Rise of Fintech & A Strong Alliance 

To ease hurdles in securing working capital loans, the government has devised many schemes for MSME financing, however, the lengthy procedures for loans often end up hindering MSMEs at crucial stages of growth by restricting their cash conversion cycle. This has led to a significantly undercapitalised MSME segment in the country with a huge credit gap of Rs 32.5 trillion. 

MSMEs have long been facing a problem of delayed realization of their bills and receivables, particularly from their large corporate buyers and government organizations. As a result, MSMEs face financial hardships and liquidity constraints which lead to severe pressure on their working capital management and many of them turn into non-performing assets (NPAs). This severely affects the sustainability of their operations. 

A radical transformation of the finance sector and the rise of fintech-enabled alternative lending are helping remedy this. The advent of digitization in the lending space is one giant leap for SME financing as it is estimated that the total potential for lending to this sector is today close to $100 billion in annual disbursements across the 63 million MSMEs estimated in India.

While the new budget restoring confidence in NBFCs by creating a Rs 1 lakh crore securitization facility with government guarantee is a promising sign, it is clear that digital lending will be a strong ally of MSME financing with customer-oriented transactions, customized loans, speedy disbursals and minimal paperwork- a win-win for the MSME sector.

However, boosting cash conversion cycles requires major fiscal policy initiatives and improved financial literacy for small business owners. MSMEs need access to working capital in days, not weeks. Simplifying this process can further boost the economy and create jobs.

(R Narayan, Senior Vice President, FICCI-CMSME and Founder & CEO at Power2SME. Views expressed are the author’s own.)

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