Working Capital Management

REVIEWED BY ALICIA TUOVILA

Updated Oct 4, 2019

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. 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.

Working Capital
Understanding Working Capital Management
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.

KEY TAKEAWAYS

 Working Capital Management requires monitoring a company's assets and

liabilities to maintain sufficient cash flow.
 The strategy involves tracking three ratios: the working capital ratio, the
collection ratio, and the inventory ratio.
 Keeping those three ratios at optimal levels ensures efficient working
capital management.
Current liabilities are any obligations due within the following 12 months. These
include operating expenses and long-term debt payments.

Ratio Analysis
Working capital management commonly involves monitoring cash flow, current
assets, and current liabilities through ratio analysis of the key elements of
operating expenses, 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.
Benefits of Working Capital Management
Working capital management can improve a company's earnings and profitability
through efficient use of its resources. Management of working capital includes
inventory management as well as management of accounts receivables and
accounts payables.

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.

Types of Working Capital Management Ratios

There are three ratios that are important in working capital management: 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.
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 securing
financing appropriately or managing its working capital efficiently.

The Collection Ratio

The collection ratio 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.