A:

Proper management of working capital is essential to a company’s fundamental financial health and operational success as a business. A hallmark of good business management is the ability to utilize working capital management to maintain a solid balance between growth, profitability and liquidity.

A business uses working capital in its daily operations; working capital is the difference between a business' current assets and current liabilities or debts. Working capital serves as a metric for how efficiently a company is operating and how financially stable it is in the short-term. The working capital ratio, which divides current assets by current liabilities, indicates whether a company has adequate cash flow to cover short-term debts and expenses.

The Importance of Working Capital

Working capital is a daily necessity for businesses, as they require a regular amount of cash to make routine payments, cover unexpected costs and purchase basic materials used in production of goods. Working capital is an easily understandable concept, as it is linked to an individual’s cost of living and, thus, can be understood in a more personal way. Individuals need to collect money they are owed and maintain a certain amount on a daily basis to cover day-to-day expenses, bills and other regular expenditures.

Working capital is a prevalent metric for the efficiency, liquidity and overall health of a company. It is a reflection of the results of various company activities, including revenue collection, debt management, inventory management and payments to suppliers. This is because it includes inventory, accounts payable and receivable, cash, portions of debt due within the period of a year and other short-term accounts.

The needs for working capital vary from industry to industry, and they can even vary among similar companies. This is due to several factors, including differences in collection and payment policies, the timing of asset purchases, the likelihood of a company writing off some of its past-due accounts receivable, and in some instances, capital-raising efforts a company is undertaking.

The Importance of Working Capital Management

When a company does not have enough working capital to cover its obligations, financial insolvency can result and lead to legal troubles, liquidation of assets and potential bankruptcy. Thus, it is vital to all businesses to have adequate management of working capital.

Working capital management is essentially an accounting strategy with a focus on the maintenance of a sufficient balance between a company’s current assets and liabilities. An effective working capital management system allows businesses to not only cover their financial obligations, but it is also a way to help companies boost their earnings. Managing working capital means managing inventories, cash, accounts payable and accounts receivable. An efficient working capital management system often uses key performance ratios, such as the working capital ratio, the inventory turnover ratio and the collection ratio, to help identify areas that require focus in order to maintain liquidity and profitability.

RELATED FAQS
  1. Does working capital measure liquidity?

    Learn about working capital and liquidity, and how working capital measures the liquidity, efficiency and overall health ... Read Answer >>
  2. What does low working capital say about a company's financial prospects?

    Find out what it means when a company has low working capital, including how this metric is interpreted based on business ... Read Answer >>
  3. What can working capital be used for?

    Find out what working capital is used for, including how to calculate this financial metric by subtracting current liabilities ... Read Answer >>
  4. Can working capital be too high?

    Learn more about the working capital ratio, and understand how an excessively high ratio can be considered a negative in ... Read Answer >>
  5. How does working capital management affect corporate earnings?

    Understand why it is critically important for companies to efficiently manage their working capital and how working capital ... Read Answer >>
  6. How can an investor determine the efficiency of a company's working capital management?

    Learn how working capital is vital to a company’s survival. Also learn key metrics investors use to assess how efficiently ... Read Answer >>
Related Articles
  1. Investing

    Calculating Days Working Capital

    A company’s days working capital ratio shows how many days it takes to convert working capital into revenue.
  2. Small Business

    Retail vs. Tech: How These Companies Use Working Capital

    Learn about the difference between retail and tech businesses' use of working capital and why working capital varies so widely in the technology sector.
  3. Investing

    The Working Capital Position

    Learn how to correctly analyze a company's liquidity and beat the average investor.
  4. Investing

    Useful Balance Sheet Metrics

    These metrics can help you better understand the information found on balance sheets.
  5. Investing

    Liquidity Measurement Ratios

    Learn about the current ratio, quick ratio, cash ratio and cash conversion cycle.
  6. Investing

    Current Liabilities

    Current Liabilities are company debts due within one year or one operating cycle, whichever is greater. An operating cycle is the time it takes a company to purchase inventory and convert it ...
  7. Investing

    The Optimal Use Of Financial Leverage In A Corporate Capital Structure

    The amount of debt and equity that makes up a company's capital structure has many risk and return implications.
  8. Investing

    Dynamic Current Ratio: What It Is And How To Use It

    Learn why this ratio may be a good alternative to the current, cash and quick ratios.
  9. Investing

    3 Companies With Low Working Capital (AREX, NDLS)

    Learn about low working capital, how to calculate it, how it can impact a company's outlook and three stocks that currently feature weak working capital.
  10. Small Business

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
RELATED TERMS
  1. Working Capital Management

    A managerial accounting strategy focusing on maintaining efficient ...
  2. Days Working Capital

    An accounting and finance term used to describe how many days ...
  3. Gross Working Capital

    The sum of all of a company's current assets (assets that are ...
  4. Capital Investment

    Funds invested in a firm or enterprise for the purposes of furthering ...
  5. Liquidity Ratios

    A class of financial metrics that is used to determine a company's ...
  6. Working Capital Loan

    A loan whose purpose is to finance everyday operations of a company. ...
Hot Definitions
  1. Retirement Planning

    Retirement planning is the process of determining retirement income goals and the actions and decisions necessary to achieve ...
  2. Drawdown

    The peak-to-trough decline during a specific record period of an investment, fund or commodity. A drawdown is usually quoted ...
  3. Inverse Transaction

    A transaction that can cancel out a forward contract that has the same value date.
  4. Redemption

    The return of an investor's principal in a fixed income security, such as a preferred stock or bond; or the sale of units ...
  5. Solvency

    The ability of a company to meet its long-term financial obligations. Solvency is essential to staying in business, but a ...
  6. Dilution

    A reduction in the ownership percentage of a share of stock caused by the issuance of new stock. Dilution can also occur ...
Trading Center