The concept of working capital management is crucial to the successful running of enterprises. It is based on the premise of managing a company’s short-term assets and liabilities. This guide will reveal everything you need to understand working capital management to help your business grow and reap the benefits.
What is working capital management?
Most likely, you have a question, “What do you mean by working capital management?”. Its definition is managing a company’s short-term assets and liabilities, which is necessary to ensure the enterprise has the liquidity it needs to meet its obligations and continue operating smoothly. Primarily, working capital management makes a business capable of meeting its short-term operating costs and liabilities. What are the types of working capital? It includes cash, accounts receivable, inventory, accounts payable, etc.
In other words, working capital management is concerned with ensuring that a business has enough cash to meet its current obligations. Therefore, it is vitally important that the company’s executives contemplate the introduction of working capital management.
There are a few different ways to manage working capital, but one of the most important is to ensure that invoices are taken care of promptly. This means working with customers to arrange for timely payment and with suppliers to ensure that inventory is paid for on time, preferably near the end of the credit period.
If a company needs more capital, it may be forced to sell assets or take out loans to meet its obligations. This mechanism can lead to higher interest payments and put the company at risk of defaulting on its debt. So, knowing the scope of working capital is paramount for every business.
Understanding working capital management
Having an explicit understanding of working capital management is vitally significant. It’s a fundamental part of financial management and one of the most critical indicators of a company’s overall financial health.
There are a number of different ways to manage working capital. Some standard methods include optimizing accounts receivable and accounts payable processes, managing inventory levels, and reducing overhead costs.
Each company is different, so there’s no one-size-fits-all approach to working capital management. The key is to tailor a working capital policy to the specific needs of your business.
Deploying principles of working capital management can have several benefits for your business, including:
- Increasing profitability;
- Reducing the risk of bankruptcy;
- Improving cash flow;
- Freeing up working capital for other purposes.
Working capital management is an ideal starting point if you’re looking for ways to improve your company’s financial health. It can be a complex and challenging endeavor, but it can pay off handsomely for businesses that can master it.
Why manage working capital?
As Dan Corredor, President at The Strategic CFO, said, “Working capital is like your diet; if you do not manage it, then it can kill you”.
There are many reasons why capital management is fundamental. First, it helps businesses to keep their doors open and continue operating. Without working capital, companies would not be able to pay their employees or suppliers, eventually leading to the business shutting down.
Further, with adequate working capital, a company could pay its bills, expand its operations, or take advantage of new opportunities. Having enough working capital to cover operating expenses and fund growth is essential.
In the end, studying financial management, international practices, and types of working capital will prove handy to let a business sustain itself in the long run. A company should never forget to make working capital management notes, as they will streamline its internal systems.
Working capital management ratios
Ratios are the tools of working capital management that can be utilized to make progressive decisions. The following ones help define working capital management in the best way possible:
The current or working capital ratio is calculated by dividing current assets by current liabilities. This ratio demonstrates a company’s short-term liquidity position and ability to meet its short-term obligations.
A high working capital ratio indicates that the firm is in an excellent position to pay off its short-term liabilities. On the other hand, if this ratio is too low, it might indicate that the business is having difficulty meeting its obligations.
Collection ratio (Days Sales Outstanding)
Collecting days’ sales outstanding ratio is a tool to measure accounts receivable. The collection ratio is calculated as follows:
Collection Ratio = 365 Days * (Average Accounts Receivable/Net Credit Sales)
This ratio will give you an idea of how many days the business takes to collect its receivables. Generally, a company wants a ratio of as less as possible. A lower number means that the firm is assembling its receivables quicker, while a higher number indicates that it is taking longer and impacting the capital management cycle.
Inventory turnover ratio
Another essential component of working capital is the inventory turnover ratio. This metric measures the number of times inventory is sold or used over a set period, usually one year. A high ratio means the company may be sitting on too much stock.
Ideally, the firm wants its inventory turnover ratio to be as high as possible. That way, it is not tying up too much working capital in inventory which is just sitting around gathering dust.
It is calculated as “Cost of goods sold / Average inventory”,
where average inventory = (beginning inventory + ending inventory) / 2.
To better understand the meaning of working capital management for business, let’s answer some frequently asked questions.
What is working capital management?
Working capital management is the process of monitoring and regulating a company’s working capital position. It includes managing inventory, accounts receivable, accounts payable, etc. The goal of working capital management is to ensure that a firm has enough cash on hand to meet its short-term obligations.
Why is the current ratio important?
Creditors and investors use it to assess a company’s liquidity and ability to meet short-term obligations. The current ratio can also be used by management to measure the business’s working capital position.
Why is the collection ratio important?
The collection ratio is a critical metric of working capital management that measures a company’s ability to collect its receivables in a timely manner. A high collection ratio means that a firm is collecting payments quickly and effectively, while a low value indicates it may have difficulty with it.
Why is the inventory ratio important?
This ratio is important because it reflects how effectively a business sells its stocks. A relatively low ratio in relevance with industry rivals reflects a risk that inventory levels are excessively high, while a relatively high one may indicate inadequate levels.
Working capital management is a key part of any business. It helps companies to track their finances and ensure they have the funds they need to grow and operate smoothly. By carving defining principles of working capital and implementing their own management policy, enterprises can get the most out of their liquid assets and ensure they have the financial resources they need to succeed.