What Is Working Capital Management? (Importance And Ratios)

By Indeed Editorial Team

Published 4 May 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

A company's capital is anything that adds value or benefit to it, such as the facilities where it carries out its production, patents and financial assets. Managing the capital in a way that enhances returns is the primary objective of any business, and working capital management helps with that. Mastering how to do this well can be pivotal in determining the success, growth and viability of the business. In this article, we discuss what working capital management is, outline its components, review some factors that affect working capital and discuss why working capital management is important.

What is working capital management?

While answering 'What is working capital management?', it is important to understand its purpose. Working capital management is the management of a company's current assets and current liabilities in a strategic manner so that it derives maximum gains in the short term. It is a strategy that encourages businesses to use their assets most efficiently. Working capital management works by monitoring and reducing operating costs and inventory management, thus increasing returns. There are various factors that can impact how much working capital is available in a company. Depending on those factors, the strategies to manage it may differ.

Related: Basics Of Accounting - Terminology, Principles And Concepts

Components of working capital management

There are two major components that are used to determine the working capital of a business. You can calculate working capital by subtracting the value of current liabilities from that of the current assets. These major components include:

Current assets

All liquid assets or assets that a business can convert into usable cash, sell or consume within a year are called current assets. They feature on the balance sheets of a company. Here are some examples of current assets:

Cash and cash equivalents

Cash is the most liquid asset owned by a company. It includes money in the bank. There are other easily liquefiable assets that a business can quickly convert into cash. These are called cash equivalents. Examples of cash equivalents are marketable securities, commercial paper, short-term bonds, bills, and money market holdings.

Cash equivalents are those assets or investments that are short term and can mature within three months. They can easily get sold in the market because of plenty of buyers being available for them. They also come with specified market prices or known values attached to them and are low-risk assets.

Accounts receivable

Accounts receivable is the money that a customer owes to a company owing to outstanding or unpaid invoices. For example, a mobile phone service provider that offers postpaid plans charges the customers monthly for calling, mobile data and texting services that they have already used the previous month. Some companies may allow only their VIP customers to purchase products or services on credit, creating accounts receivable. Accounts receivable features on the balance sheet and is an asset because it is money the company expects to receive in the short term.

Related: Revenue Accounts: With Definition, Types And Examples

Stock inventory

Inventory includes all the items or raw materials that are ready and available for sale or for use in production. Inventories are counted as assets because they generate income for the business as they get sold or by helping create other products. Examples of inventory include raw materials, component parts, packing materials, finished goods and extra stock. As long as there are enough potential buyers in the market, stock inventory is of value.

Marketable securities

Marketable securities consist of those monetary or financial instruments that you can convert into cash for a fair price. They usually mature within a year and include securities like treasury bills and stocks. You can buy them on exchanges, and they can be both equity or debt securities.

Prepaid liabilities

Prepaid liabilities are the goods or services that a company has already paid for in advance. They receive these goods and services in the ensuing period. Examples of prepaid liabilities or expenses include salaries of employees, office equipment on lease, office space for which the company has already paid the rent, and insurance policies which are for unforeseen and unfortunate events in the future. They get considered as assets in the balance sheet because the company has already paid for them and can continue to derive benefits from them for a period of time in the future.

Current liabilities

Current liabilities are a company's financial commitments in the short-term or that are due in less than a year. They usually pay their current liabilities through their current assets. Here are some examples of current liabilities:

Accounts payable

Money that a company owes to its creditors or suppliers gets referred to as accounts payable. You may consider this as the reverse of accounts receivable. Examples may include any outstanding bills, shipments with supplier terms and utility charges.

Short-term debt

Debts that are taken for the short-term and required to be paid off in under a year are called short-term debts. These are usually for operational reasons. Examples of short-term debts include short-term bank loans, commercial paper and income taxes payable.

Dividends

Dividends are profits that are paid out to the shareholders periodically at the discretion of the company. The stock prices increase and decrease slightly before and after they have paid the dividends out. The company's board of directors decides the dividend amounts.

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Notes payable

This is the money that the company owes to its financial backers, like banks and other financial institutions. Sometimes, business owners of start-ups may initially borrow money from friends or family to start the business. This also counts as notes payable. Notes payable are long-term liabilities.

Factors that affect working capital

There are various factors that affect the working capital of a company. Some of these factors are:

  • company size

  • company structure

  • overall business strategy

  • access to banking services

  • type of industry

  • level of interest rates

  • products or services sold

  • competitors

  • economic conditions

Why is working capital management important?

Every business requires working capital to meet its regular operational demands. They use this to make routine payments, purchase raw materials for production and meet unforeseen expenses. Managing the working capital well can ensure that operations run smoothly without obstructions, and the company can enjoy better returns. Working capital provides a good measure of the company's liquidity, efficiency and overall health. Working capital management is a strategy that aims to maintain a good balance between a company's current assets and liabilities. Working capital management helps identify what may be disrupting this balance and the ways to fix it.

Companies use key performance ratios to manage their working capital. These ratios track the company's current capital, inventory and cash flow. Adequate working capital management can also help companies avoid any financial pitfalls, improve business value and remain advantageous in the market against their competitors.

Common analysis ratios for working capital management

The three common analysis tools to manage working capital are current ration, collection ratio and inventory turnover ratio. Here are the detailed explanations of these ratios:

Current ratio

The current ratio compares the company's current assets to its current liabilities. It is a liquidity ratio that indicates a company's capacity to pay its short-term dues. A really low (below 1.0) current ratio signifies operational risks or distress signals. A current ratio that is equal to or slightly above the industry standard (1.2 to 2.0) is considered healthy.

A current ratio that is too high or above the industry standard can also be a cause for concern. It could mean that the current assets are not being used to their full potential to provide returns. To calculate the current ratio, you can divide the current assets by the current liabilities.

Collection ratio

The collection ratio shows the amount of time it takes for a business to extract payments on the accounts receivable. These are outstanding payments from their customers. To calculate the collection ratio, you can divide the total value receivables by the average daily sales. If the receivables are outstanding for a long period, it can mean that the business is at risk of losing the receivable amount. Usually, the longer the delays in receiving payments, the less likely that customer is to pay up. Also, longer wait periods may mean that a larger working capital investment may be necessary.

Inventory turnover ratio

Inventory turnover is the time it takes for a company to sell the items or products that it purchased. Companies that sell fast-moving consumer products (FMCGs) are likely to have several inventory turnovers per year, whereas those who sell expensive luxury products may sell far fewer units in a year but spend more time in the production of these items.

The inventory turnover ratio indicates how many times a company sells and replenishes its inventory over a specified period of time. You can calculate this by dividing the cost of goods sold (COGS) by the average inventory for that period. If this ratio is high, it could imply strong sales.

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