Posted by: Niyati on Thu, Sep 27th, 2018
What are Basic Concepts of Working Capital Management?
Working capital management is a key indicator of the ability of a firm to manage its short-term (a year or lesser) liquidity needs and to ensure efficient operations from a management standpoint. It refers to the financing required for current assets such as cash, marketable securities, accounts receivable, and inventory. Such financing usually needs to be met through current liabilities such as accounts payable, short-term debt, and interest payable.
The main objective of working capital management is to ensure that the company has sufficient financing means for short-term operating costs and other short-term obligations.
What is Working Capital?
In simple terms, working capital is the difference between current assets and current liabilities.
Net Working Capital = Current Assets – Current Liabilities.
Current assets are short-term in nature. They usually have a lifetime of one year and can be liquidated or converted to cash within a year. This asset category includes cash and cash equivalents, marketable securities and investments that can be easily liquidated or sold, assets held for trading or sale, such as certain shares or bonds, inventories, receivables, accrued income, prepaid taxes, and prepaid expenses.
Current liabilities need to be paid off within a year, such as short-term loans, payables to suppliers or vendors, accrued expenses, interest payable, portions of long-term debt that are due/maturing this year, provisions for expenditures, taxes payable this year.
As is arithmetically obvious, an increase in working capital indicates that current assets have increased, or current liabilities have decreased or both. This can occur in situations where inventories have increased, account payables have decreased, receivables have increased, short-term debt payable has decreased, or combinations of such scenarios.
How Does Working Capital Work?
Not enough working capital may indicate liquidity problems. Too much working capital may indicate an inefficient use of assets.
The right strategy would be to ensure healthy levels of current assets and liabilities, relative to each other, and relative to industry peers, to meet short-term financing and operating needs of the business.
Managing working capital effectively requires a focus on key components such as cash management, inventory management, debtors (receivables) management, creditors (payables) management, short-term financing.
- Cash management refers to having sufficient cash to meet day to day operational needs, as well as associated investments of free cash.
- Inventory management refers to the adequate stocking of raw materials, work in progress, and finished goods so that supplies are available to meet production needs and sales requirements.
- Debtors (receivables) management pertains to offering a favorable credit policy to attract customers or distributors, such as days of credit, financing, and discounts.
- Creditors (payables) management revolves around negotiating good terms with suppliers and vendors that are beneficial to the business.
- Short-term financing (short-term debt) pertains to exploring and using various funding mechanisms for liquidity and to meet operational expenses, such as overdraft, short-term loans, bill discounting, and associated instruments such as letters of credit/bank guarantees. A key aspect relates to identifying sources where the cost of funds is affordable for the business.
Assessing Working Capital – Key Financial Measures
There are several key measures related to assessing working capital needs and to ensure effective and efficient working capital management.
These measures pertain to activity ratios and liquidity ratios.
Activity ratios: This category includes several ratios related to asset utilization or turnover ratios. Some of those applicable to working capital management are receivables turnover, days sales outstanding, inventory turnover, days of inventory on hand, payables turnover, number of days of payables, and working capital turnover.
Liquidity ratios: Liquidity in this context refers to the ability of the firm to pay short-term obligations as they come due. Some of the liquidity ratios in the context of working capital management include current ratio, quick ratio, cash ratio, defensive interval ratio, and the cash conversion cycle.
A current ratio that calculates to greater than 1 is generally considered as a reasonable indicator of adequate working capital management.
Current Ratio = Current Assets / Current Liabilities
The cash conversion cycle provides an end-to-end view in that it is the length of time it takes to turn the firm’s cash investment in inventory back into cash in the form of collections from the sales of such inventory.
Cash Conversion Cycle = Days Sales Outstanding + Days of Inventory on Hand – Number of Days of Payables
High cash conversion cycles are considered undesirable as it may indicate that an excessive amount of capital is invested for actually selling goods. A low cash conversion cycle indicates that a firm can easily recover the cash invested in manufacturing or services through the collections in the form of cash from its customers as proceeds of sales.
Many of the above measures need to be compared with industry-wide firms and peer groups to assess the position of the firm as regards working capital management.
Efficient and effective working capital management is key to ensuring continued operations and to maintain the ability to meet short-term funding requirements. These are an important construct of a firm’s capability to remain a ‘going concern’, meet customer expectations of on-time delivery, and provide and receive credit in an atmosphere that ensures smooth production and sales.
If you are looking to develop expertise in the area of working capital management, or you are in a role that requires you to understand these concepts better or even a student of finance, consider enrolling for an online course on Working Capital Management to get the basics right, so that the foundations are in place as you navigate the road ahead.