What Is Working Capital Management?

Working capital management meaning in simple words translates to a business strategy to ensure that a company operates in the most efficient manner by controlling and using its current assets and liabilities optimally.

The concept of working capital management, including securing a working capital loan when necessary, states that a business must monitor its assets and liabilities to ensure it has sufficient cash flow to meet its daily operations and obligations in the short-term.

Working Capital Management Ratios

The smooth working of a business hinges on working capital management. This section looks at some metrics to gauge its efficiency. These are ratios that indicate whether a business has adequate liquidity to operate smoothly.

Current Ratio

Current ratio or working capital ratio is a ratio of current assets to current liabilities. The ratio is an important indicator of a business’s health and its ability to meet short-term financial obligations.

If the current ratio is below 1, it implies that the business may find it difficult to meet its short-term obligations. The business’s short-term debt exceeds its short-term assets and this may lead the company to monetise its long-term assets or resort to external financing.

If the current ratio is between 1.2 to 2, it means the business has more current assets than its current liabilities.

A ratio of over 2 means that the business is under-utilising its assets and needs to utilise the same to increase revenues.

The current ratio is given by the formula

Current Ratio = Current Assets/Current Liabilities

Collection Ratio

The collection ratio, also called the ‘days sales outstanding’ indicates a business’ efficiency in managing its account receivables. The collection ratio tells the average number of days in which the company receives payment after a sales transaction on credit. If the business’s billing department is effective at collecting accounts receivables, it will get quicker access to cash which it can invest for growth. A long outstanding period means the business is letting creditors enjoy interest-free loans.

The collection ratio is given by the formula:

Collection Ratio: (The number of days in the accounting period *Avg. Outstanding Accounts Receivables)

Total amount of net credit sales during the accounting period.

Inventory Turnover Ratio

For a business to operate efficiently, a company has to keep enough inventory on hand to meet the customers’ needs. A higher ratio means reduced storage and other holding costs. While a lower ratio implies excess inventory, poor sales or inefficient inventory management.

Inventory Turnover Ratio: Cost of Goods Sold/Avg. balance in inventory

While the above are important metrics that help understand the various aspects of a business operations, businesses also additionally rely on other metrics to manage working capital.

Working Capital Cycle

The working capital cycle is a measure of time it takes for a business to convert its current assets into cash. It is the period from the days when the business pays for raw material or the inventory to the time when it receives payment on the sale of its products.

Effective working capital management ensures smooth functioning of the net operating cycle, called the Cash Conversion Cycle (CCC). This is the minimum duration for a business to convert its assets into cash.

Working Capital Cycle is given by the formula:

Working Capital Cycle in Days: Inventory Cycle + Receivable Cycle - Payable Cycle

Inventory Cycle

The inventory cycle is the time it takes for a business to procure the raw material, convert into finished goods and store them till they are sold. Here again, the working capital is tied up in inventories first as raw material and then as finished goods till they are sold off.

Accounts Receivable Cycle

After the goods are sold to the customers, there is a time gap in receiving the payments from the customers. In other words, the accounts receivable cycle is the time it takes for a business to collect payment after the sale of goods or services. Although the sale is made, the company’s working capital is tied up in accounts receivables as the sales proceeds are yet to be received.

Accounts Payable Cycle

The accounts payable cycle is the time a business takes to pay its suppliers for goods and services it received. Here again, the working capital is tied up in cash, and the payables become a liability that needs to be paid off. While, on the other hand it can also be seen as a short-term loan from the supplier in that, the company still retains its cash even after receiving the goods or the service.

Limitations of Working Capital Management

Even as working capital management is an immensely useful strategy for business owners to assess various aspects of their business operations, it is not without some lacunae. Some of these are:

1. It only focuses on the short-term position of its assets, liabilities and financial obligations. It does not take into account the long-term view and may lead a business to compromise on the long-term solution for short-term benefits.

2. Even with astute working capital management practices by a business, the macroeconomic conditions can play out very differently as against the expectations.

3. Even the best working capital management plan may not guarantee profitability for a business. A company still has to focus on sales growth, controlling costs and other measures to improve profits.

In simple words, working capital management has four crucial variables, namely, cash, payables, receivables and inventory. It is a delicate balance of these four items of a business’s balance sheet. Efficient working capital management helps a business to have enough liquidity so as to be in sound health. By using its resources efficiently, a working capital management strategy helps a business to improve its cash flow management and earnings quality.