Working capital management is a business strategy that helps a company manage its current assets and liabilities to their most effective use. The purpose of working capital management is to maintain enough cash flow to meet operating costs and debt obligations.
What are the main components of working capital management?
While companies may compare all of their current assets and liabilities, there are a few components that are especially important:
- Cash- Organizations can manage their cash flow by predicting needs, monitoring balances, and optimizing incoming and outgoing flows to meet any obligations.
- Inventory- Through their preferences, customers determine how much inventory is translated into cash. If inventory is high, the business may need to reduce prices to sell inventory.
- Accounts receivable- Businesses must manage their credit policies, thoroughly check customer payments, and improve collection practices. If any one of these practices or policies isn’t effective, the company may not be able to collect cash.
- Payables- Companies can fine-tune how they pay suppliers, define the credit terms, and when to make cash outlays.
- Short-term capital- These are funds that help businesses run the day-to-day operations (rent, utilities, advertising, risk management, and so on).
What are the working capital ratios?
Similarly to working capital management, working capital ratios measure a company’s current assets against their current liabilities, using this calculation:
Working Capital Ratio = Current Liabilities
Using this method, a working capital ratio below one indicates a company can’t pay their short-term debts. A working capital ratio that is very high, however, indicates that a company is ahead of their debts, but has excess cash sitting around that could be managed more effectively. Depending on the industry, an ideal score may be between 1.5 and 2, but it is important to compare the company’s ratio to those of competitors within the industry.
What are the types of working capital management?
Working capital is the difference between your assets and liabilities. A few different types of working capital include:
- Permanent working capital- the amount of resources the company needs to operate its business.
- Regular working capital- part of the permanent working capital that’s necessary for day-to-day operations.
- Reserve working capital- Another component of permanent working capital. Companies may require additional working capital for emergencies, seasonality, or unforeseen events.
- Fluctuating working capital- Variable working capital, such as inventory. Fluctuating working capital only includes variable liabilities the company can control.
- Gross working capital- The total amount of current assets before including any short-term liabilities.
- Net working capital- The difference between current assets and current liabilities.
Why manage working capital?
Managing working capital can help a company better run their cash flow and monitor their earnings by examining the most efficient use of resources. Managing working capital also entails going over inventory, accounts receivable, and accounts payable.