What Is Working Capital Management?
Efficient management of working capital ensures profitability and overall financial health for businesses. Working capital is the cash that companies use to operate and conduct their organizations. Effective working capital management ensures that a company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
The elements of working capital that investors and analysts assess to evaluate a company determine a company's cash flow. These elements are money coming in, money going out, and the management of inventory.
Working Capital Management Deconstructed
Effective working capital management requires coordinating several tasks such as managing short-term investments, granting credit to customers and collecting on this credit, managing inventory, and managing payables. Effective working capital management also requires obtaining reliable cash forecasts and accurate data on transactions and bank balances.
If a company has insufficient cash to pay for its current expenses, it may have to file for bankruptcy, undergo restructuring by selling off assets, reorganize, or liquidate. Conversely, if a company invests excessively in cash and liquid assets, this may be a poor use of company resources.
- Working capital management is crucial to ensure that a company maintains sufficient cash flow to meet its short-term operating costs and obligations.
- The elements of working capital are money coming in, money going out, and the management of inventory.
- Companies must also prepare reliable cash forecasts and maintain accurate data on transactions and bank balances.
- If a company cannot meet its short-term obligations, it may face bankruptcy while holding excessive liquid assets or cash may not be the best use of its resources.
These are three main components associated with working capital management:
1. Accounts Receivable
Accounts receivable are revenues due—what customers and debtors owe to a company for past sales. A company must collect its receivables in a timely manner so that it can use those funds to meet its own debts and operational costs. Accounts receivable appear as assets on a company's balance sheet, but they do not become assets until they are collected. Days sales outstanding is a metric used by analysts to assess a company's handling of accounts receivables. The metric reveals the average number of days a company takes to collect sales revenues.
2. Accounts Payable
Accounts payable is the amount that a company must pay out over the short term and is a key component of working capital management. Companies endeavor to balance payments with receivables to maintain maximum cash flow. Companies may delay payments as long as is reasonably possible with the goal of maintaining positive credit ratings while sustaining good relationships with suppliers and creditors. Ideally, a company's average time to collect receivables is significantly shorter than its average time to settle payables.
Inventory is a company's primary asset that it converts into sales revenues. The rate at which a company sells and replenishes its inventory is a measure of its success. Investors also consider the inventory turnover rate to be an indication of the strength of sales and how efficient the company is in its purchasing and manufacturing. Low inventory means that the company is in danger of losing out on sales, but excessively high inventory levels could be a sign of wasteful use of working capital.
Working Capital Management in a Nutshell
Working capital management represents the relationship between a firm's short-term assets and its short-term liabilities. The goal of working capital management is to ensure that a company can afford its day-to-day operating expenses while, at the same time, investing the company's assets in the most productive way. A well-run firm manages its short-term debt and current and future operational expenses through its management of working capital, the components of which are inventories, accounts receivable, accounts payable, and cash.