Working capital management is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to the best effect. The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
A company’s working capital is made up of its current assets minus its current liabilities.
Understanding Working Capital Management
Current assets include anything that can be easily converted into cash within 12 months. These are the company’s highly liquid assets. Some current assets include cash, accounts receivable, inventory, and short-term investments.
- Working Capital Management requires monitoring a company’s assets and liabilities to maintain sufficient cash flow.
- The strategy involves tracking three ratios: the working capital ratio, the collection ratio, and the inventory ratio.
- Keeping those three ratios at optimal levels ensures efficient working capital management.
Current liabilities are any obligations due within the following 12 months. These include operating expenses and long-term debt payments.
Working capital management commonly involves monitoring cash flow, current assets, and current liabilities through ratio analysis of the key elements of operating expenses, including the working capital ratio, collection ratio, and inventory turnover ratio.
Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net current assets and liabilities into cash.
Benefits of Working Capital Management
Working capital management can improve a company’s earnings and profitability through efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivables and accounts payables.
The objectives of working capital management, in addition to ensuring that the company has enough cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and maximizing the return on asset investments.
Types of Working Capital Management Ratios
There are three ratios that are important in working capital management: The working capital ratio or current ratio; the collection ratio, and the inventory turnover ratio.
Working capital management aims at more efficient use of a company’s resources.
The working capital ratio or current ratio is calculated as current assets divided by current liabilities. It is a key indicator of a company’s financial health as it demonstrates its ability to meet its short-term financial obligations.
Although numbers vary by industry, a working capital ratio below 1.0 generally indicates that a company is having trouble meeting its short-term obligations. That is, the company’s debts due in the upcoming year would not be covered by its liquid assets. In this case, the company may have to resort to selling off assets, securing long-term debt, or using other financing options to cover its short-term debt obligations.
Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may suggest that the company is not effectively using its assets to increase revenues. A high ratio may indicate that the company is not securing financing appropriately or managing its working capital efficiently.
The Collection Ratio
The collection ratio is a measure of how efficiently a company manages its accounts receivables. The collection ratio is calculated as the product of the number of days in an accounting period multiplied by the average amount of outstanding accounts receivables divided by the total amount of net credit sales during the accounting period.
The collection ratio calculation provides the average number of days it takes a company to receive payment after a sales transaction on credit. If a company’s billing department is effective at collections attempts and customers pay their bills on time, the collection ratio will be lower. The lower a company’s collection ratio, the more efficient its cash flow.
The Inventory Turnover Ratio
The final element of working capital management is inventory management. To operate with maximum efficiency and maintain a comfortably high level of working capital, a company must keep sufficient inventory on hand to meet customers’ needs while avoiding unnecessary inventory that ties up working capital.
Companies typically measure how efficiently that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as revenues divided by inventory cost, reveals how rapidly a company’s inventory is being sold and replenished. A relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.