Working Capital Management
Working capital management is a business tool that helps companies effectively make use of current assets, helping companies to maintain sufficient cash flow to meet short term goals and obligations. By effectively managing working capital, companies can free up cash that would otherwise be trapped on their balance sheets. As a result, they may be able to reduce the need for external borrowing, expand their businesses, fund mergers or acquisitions, or invest in R&D.
Working capital is essential to the health of every business, but managing it effectively is something of a balancing act. Companies need to have enough cash available to cover both planned and unexpected costs, while also making the best use of the funds available. This is achieved by the effective management of accounts payable, accounts receivable, inventory and cash.
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.
Objectives of Working Capital Management
Smooth Operating Cycle: The key objective of working capital management is to ensure a smooth operating cycle. It means the cycle should never stop for the lack of liquidity whether it is for buying raw material, salaries, tax payments etc.
Lowest Working Capital: For achieving the smooth operating cycle, it is also important to keep the requirement of working capital at the lowest. This may be achieved by favorable credit terms with accounts payable and receivables both, faster production cycle, effective inventory management etc.
Minimize Rate of Interest or Cost of Capital: It is important to understand that the interest cost of capital is one of the major costs in any firm. The management of the firm should negotiate well with the financial institutions, select the right mode of finance, maintain optimal capital structure etc.
Optimal Return on Current Asset Investment: In many businesses, you have a liquidity crunch at one point of time and excess liquidity at another. This happens mostly with seasonal industries. At the time of excess liquidity, the management should have good short-term investment avenues to take benefit of the idle funds.
Components of 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 appears 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 endeavour 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.
Importance of Working Capital Management
Although the importance of working capital is unquestionable in any type of business. Working capital management is a day-to-day activity, unlike capital budgeting decisions. Most importantly, inefficiencies at any levels of management have an impact on the working capital and its management. Following are the main points that signify why it is important to take the management of working capital seriously.
Ensures Higher Return on Capital
Improvement in Credit Profile & Solvency
Business Value Appreciation
Most Suitable Financing Terms
Interruption Free Production
Readiness for Shocks and Peak Demand
Advantage over Competitors
Working Capital Ratios
There are three ratios that are important in working capital management: The working capital ratio or current ratio; the collection ratio, and the inventory turnover ratio.
Current Ratio (Working Capital Ratio)
The working capital ratio or current ratio is calculated as current assets divided by current liabilities. It is a key indicator of a company's financial health as it demonstrates its ability to meet its short-term financial obligations.
Although numbers vary by industry, a working capital ratio below 1.0 generally indicates that a company is having trouble meeting its short-term obligations. That is, the company's debts due in the upcoming year would not be covered by its liquid assets. In this case, the company may have to resort to selling off assets, securing long-term debt, or using other financing options to cover its short-term debt obligations.
Working capital ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may suggest that the 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 is a 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 pay 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 keep sufficient inventory on hand to meet customers' needs while avoiding unnecessary inventory that ties up working capital.
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.
Working Capital Deciding Factors
The two main factors that decide the quantum of working capital that a business should maintain, are liquidity and profitability. Let’s understand the impact of both of these factors in details.
We know that a business can’t sit on unlimited or too high liquidity because higher liquidity means higher investment in working capital. And higher investment in working capital means higher cost of capital, interest cost in case financed by bank finance. Therefore, the higher liquidity has a direct impact on the profitability as the capital cost rises. In essence, the relation between liquidity and profitability is inverse. On one hand, higher rather sufficient liquidity is the primary goal of working capital management. Whereas on the other hand, profitability as an objective aligns with the overall objective of an organization i.e., wealth maximization.
With that, it is quite clear that a policy that an organization follows would fall between these pillars. There may be policies that are tilted towards liquidity and others may be towards profitability. It is then a management decision where do they want to place their organization’s policy.