WORKING CAPITAL MANAGEMENT

Working capital management is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to their most effective use. It requires monitoring a company’s assets and liabilities to maintain sufficient cash flow to meet its short-term operating costs and obligations to maximize profitability.

A company’s working capital is made up of its current assets minus its current liabilities.

Current assets include anything that can be easily converted into cash within 12 months. These are the company’s highly liquid assets. Some current assets include cash, accounts receivable, inventory, and short-term investments. Current liabilities are any obligations due within the following 12 months. These include accruals for operating expenses and current portions of long-term debt payments.

Why Manage Working Capital?

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.

It also entails improving a company’s cash flow management and earnings quality through the efficient use of its resources including inventory management, accounts receivable and accounts payable.

Working capital management also involves the timing of accounts payable. A company can conserve cash by choosing to stretch the payment of suppliers and to make the most of available credit.

In addition to ensuring that the company has enough cash to cover its expenses and debt, are minimizing the cost of money spent on working capital and maximizing the return on asset investments.

Working Capital Management Ratios

The efficiency of working capital management (WCM) can be quantified using ratio analysis.

The three key ratios are working capital ratio (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 managing its working capital efficiently.

Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as Days Sales Outstanding (DSO), is a measure of how efficiently a company manages its accounts receivable. 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 receivable 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 quickly it turns receivables into cash.