What is Working Capital Management?
Working capital management refers to a company's managerial accounting strategy designed to monitor and utilize the two components of working capital, current assets and current liabilities, to ensure the most financially efficient operation of the company. The primary purpose of working capital management is to make sure the company maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
- Working capital management is the analysis and implementation of strategies surrounding current assets and current liabilities.
- Current assets are any assets that are liquid enough to be turned into cash within the following twelve month period.
- Current liabilities are obligations due within the upcoming twelve month period.
- A financially efficient company will have more than enough current assets to cover their current liabilities.
- Three key ratios in working capital management are the working capital ratio, collection ratio, and inventory turnover ratio.
How to Use Working Capital Management
Working capital is made up of current assets minus current liabilities. Current assets include any assets that can be easily converted into cash within the following twelve month period. In other words, they are highly liquid assets. Some current assets include cash, accounts receivable, inventory, and short-term investments. Current liabilities include any obligations due within the following twelve month period, such as operating expenses and the current portion of long-term debt.
Working capital management commonly involves monitoring cash flow, current assets, and current liabilities through the ratio analysis of key elements of operating expenses, including the working capital ratio, collection ratio, and the inventory turnover ratio. Efficient 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.
Working capital management can also help to improve the company's earnings and profitability through efficient use of company resources. Management of working capital includes inventory management as well as management of accounts receivables and accounts payables. The main objectives of working capital management include ensuring the company will have enough cash to cover current expenses and debt obligations, minimizing the cost of capital spent on working capital, and maximizing the return on current asset investments.
Types of Working Capital Management Ratios
Working Capital Ratio (Current Ratio)
The working capital ratio, also referred to as the current ratio, is calculated as current assets divided by current liabilities. It is considered a key indicator of a company's financial health since it indicates the company's ability to successfully meet all of its short-term financial obligations.
Although numbers vary by industry, a working capital ratio below 1.0 is generally indicative of a company having trouble meeting its short-term obligations. This would mean the company's debts due in the upcoming year are not able to be covered by its liquid assets. In this case, the company may have to resort to selling off assets, securing long-term debt, or accessing other financing options to cover their short-term debt obligations.
Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may indicate a 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, also known as the average collection period ratio, is a principal 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 are paying their bills on time, the collection ratio will be lower. The lower a company's collection ratio, the more efficient its cash flow.
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 carefully balance sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory that ties up working capital for a long period before it is converted into cash.
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.