There are a number of tools that determine how efficiently a company is managing its working capital, principally by looking at measures of inventory and cash flow.
Analysts and investors look at a company's working capital to determine its overall efficiency and financial health. Working capital is essentially the money necessary for a company to maintain its operations on a day-to-day basis. It is composed of a number of components, the three most important being:
- Accounts payable
- Accounts receivable
- Inventory levels
Accordingly, an assessment of a company's working capital management should consider the working capital ratio, the inventory turnover ratio and the collection ratio.
Working Capital Ratio
The working capital ratio shows current assets divided by current liabilities and indicates to investors and analysts whether a company has the adequate short-term assets to cover its short-term obligations. A ratio that falls somewhere between 1.2 and 2.0 is generally considered satisfactory.
Inventory Turnover Ratio
The inventory turnover ratio details the number of times a company sells and replaces its inventory over a given period of time. The formula for this ratio divides a company's sales by its inventory. High inventory turnover ratios are commonly interpreted as indicating either very vigorous sales or inefficient purchasing. To determine which is the case, analysts look at average inventory figures in addition to turnover rate. (For more, see "Reading the Inventory Turnover.")
The collection ratio provides an idea of the average time required for a company to receive the money it is due from sales to customers. Lower collection ratio values are more favorable, since the timely collection of accounts receivable is critical to ensuring a company always maintains adequate cash flow for operational expenses.
Looking at these three ratios can help analysts and investors decide whether or not the company's working capital management is efficient and if the company is a good investment.
(For related reading, see "Why Working Capital Management Matters.")