Working Capital Management

What Is 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 the best effect.

Understanding Working Capital Management

The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. 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.

Working capital management commonly involves monitoring cash flow, current assets, and current liabilities through ratio analysis of the key elements of working capital, including the working capital ratio, collection ratio, and inventory turnover ratio.

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.

Working capital management can improve a company's cash flow management and earnings quality through efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivables and accounts payables. 

Working capital management also involves the timing of payables (i.e. paying suppliers). A company can conserve cash by choosing to stretch the payment of suppliers and to make the most of available credit or may spend cash by purchasing using cash - these choices also affect working capital management.

The objectives of working capital management, 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

Three ratios that are important in working capital management are the working capital ratio or current ratio; the collection ratio, and the inventory turnover ratio.

Working capital management aims at more efficient use of a company's resources.

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 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 quickly it turns receivables into cash.

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 cost of goods sold divided by average balance sheet inventory, reveals how rapidly a company's inventory is being used in sales and replaced. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.

What Is Working Capital Management?

Working capital management involves tracking the current, collection, and inventory ratios to ensure that a company operates efficiently thereby helping to maximize a company's profitability. The primary purpose is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. 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.

Why Is the Current Ratio Important?

The current ratio (working capital ratio) is a company's 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. Current ratios of 1.2 to 2.0 are considered desirable, but a ratio higher than 2.0 may suggest that the company is not managing its working capital efficiently. Conversely, a current ratio below 1.0 generally indicates that a company's debts due in the upcoming year would not be covered by its liquid assets.

Why Is the Collection Ratio Important?

The collection ratio, or days sales outstanding (DSO), is a measure of how efficiently a company manages its accounts receivables. It 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. Essentially, this ratio shows how effective a company is at collecting payment after a sales transaction on credit. The lower a company's collection ratio, the more efficient its cash flow.

Why Is the Inventory Ratio Important?

Companies typically measure how efficiently that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as cost of goods sold divided by average balance sheet inventory, reveals how rapidly a company's inventory is being used in sales and replaced. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.