Working capital, or total current assets minus total current liabilities, refers to the additional current assets that a company holds on its balance sheet as a liquidity cushion. Most current assets are funded by current liabilities and are expected to be converted back to cash within 12 months for payments on current liabilities due in the same cycle. Certain current assets may become illiquid at the time when cash is needed to meet short-term obligations, including inventory without a ready market. To avoid any potential liquidity issues that may hamper a company's financial strength, it is financially sound to maintain a certain amount of working capital so bills are paid on time.
Increasing Investment Effectiveness
Deploying working capital can be a double-edged sword: it ensures liquidity but also ties up capital that could have been better invested elsewhere. Because working capital is the amount of current assets in excess of the amount of current liabilities, it is funded by long-term capital raised for investment purposes rather than operational maneuvers. When investment capital is allocated away for short-term uses, it potentially reduces a company's investment effectiveness. As long as liquidity concern is adequately addressed, low working capital is desired to ensure effective use of long-term funds.
Improving Operating Efficiency
The amount of working capital required each operating cycle is dependent on a company's operating efficiency. For example, the more a company can make in cash sales or the faster it can turn over inventories, the lower the amount of working capital it needs. When a company maintains a low level of working capital, it can actually force itself to improve its operating efficiency so operating cash flows, coupled with additional working capital, can safely cover costs and expenses during operations. With too much funding tied up idly in working capital for liquidity backup, a company may become less concerned about operating efficiency.
Shortening the Cash Conversion Cycle
Even with a low level of working capital, companies can still have sales on credit if they try to make the collection process as short as possible. The sooner accounts receivable are converted to cash, the less working capital is required. Inventories also potentially tie up funds for long periods of time. In addition to raw materials, finished products can remain unsold for some time, which further lengthens the cash conversion cycle. If a company wishes to maintain a low level of working capital, sales must be made promptly after production so funds stay within the cash conversion cycle for as little time as possible.
On-Demand or Just-in-Time Operations
Working capital can be reduced to as low as near zero without jeopardizing a company's ability to meet short-term obligations if the so-called on-demand or just-in-time (JIT) operations can be adopted. Under such an operating regime, a company holds little or no inventories in unused raw materials and unsold finished products. By having little or no funds parked in potentially illiquid assets, a company effectively deploys little or no working capital.
A company can achieve this stance by working in unison with raw-materials suppliers in the supply chain and sales distributors in the distribution network. In other words, a company does not purchase inventory until it is needed for production, nor does it produce anything unless sales orders are received. This way, funds designated for working capital are released and put into more productive uses.
Working capital is necessary to ensure uninterrupted operations, but it does not contribute directly to revenue generation or profitability. To the contrary, having too much working capital may hinder a company's financial results when the funds sit idle until a liquidity need arises. If a company can maintain a low level of working capital without incurring too much liquidity risk, then this level is beneficial to a company's daily operations and long-term capital investments. Less working capital can lead to more efficient operations and more funds available for long-term undertakings.