Working capital management is an important financial term. It revolves around two major financial components, namely the current assets and current liabilities. These two components make up the working capital of a business.
Working capital management deals with the managerial accounting strategies that monitor the current assets and liabilities. This is essential for a business to maintain an efficient operation of the company. An effective working capital management ensures that the business always has a sufficient cash flow to support its short-term operating costs and debt obligations.
How Does Working Capital Management Work?
The working capital management monitors the cash flow assets and liabilities. This is accomplished through ratio analysis. The ratio analysis is conducted using key elements of operating expenses. These may include the working capital ratio, collection ratio and inventory turnover ratio. The ratio analysis helps determine if the financial operation of a business is working smoothly. In the long run, efficient working capital management can help enhance the earnings and profitability of the business organization. The management may include inventory, accounts payables and account receivables management as well.
As mentioned earlier, the ratio analysis is a key element in working capital management. Let us discuss some important ratios involved in working capital management.
Working Capital Ratio
This ratio is calculated by dividing current assets by current liabilities. This will help decide how financially stable or healthy the business is. A goof working capital ratio indicates that the company can easily meet its short-term financial obligations. The figure of the ratio may vary from industry to industry. However, in general, a working capital ratio of less than 1.0 is indicative of the bad health of the business. It means there is an insufficient cash flow. A working capital ratio of 1.2 to 2.0 is preferred. On the other hand, a figure of more than 2.0 means that the assets are not being effectively used for generating revenues.
Also known as the average collection period ratio, the collection ratio indicated the effectiveness of a company’s management of accounts receivables. It is calculated by multiplying the number of days in the accounting period and the average amount of outstanding accounts receivables. This figure is then divided by the amount of net credit sales during the particular accounting period. The ratio calculates the average number of days within which the company can collect a payment. In simpler words, the ratio indicated how quickly the company is converting sales into cash. The lower the figure, the better the cash flow of the company will be.
Inventory management is also a significant element of the working capital management. Inventory management means that the company has to maintain a balance between inventory at hand to meet the customers’ demands and avoiding inventory that may tie up the working capital for a long time period prior to getting converted into cash.
To figure out a balance, the company’s financial experts have to calculate the inventory turnover ratio. This particular ratio is calculated by dividing the revenues by the cost of the inventory. The resulting figure will indicate how quickly the inventory is being sold and replenished. The figure is compared to those of others within the same industry. A high figure indicated that the efficiency of the inventory ordering can be improved while a low one tells that the inventory levels are high.
Importance of Working Capital Management
In today’s business world, the environment is highly competitive and volatile. Circumstances can be unpredictable and create as much unpredictable consequences. Therefore, it is important to maintain the financial health of a business. One of the keys to determining the financial health of a business is to manage the working capital. It allows you to identify any problems with the effectively of the cash flow and inventory conversion. When we know the problems, we can come up with quick solutions. It allows us to have a proactive approach to maintain a balance between growth, profitability and liquidity.
Working capital management helps the financial experts determine the financial health of a business in the short term. The ratios that are calculated keep the experts aware of how efficient the entire system is and if it is stable enough to support short-term obligations.
A business can have several short-term obligations. It needs cash for routine payments, materials, production goods and any other unexpected costs. A working capital for a business can be understood easily because it is quite close to how we personally manage money.
We all need a certain amount of cash on daily basis to meet certain requirements like bills, rents and grocery etc. now, if we were to run out of cash, it does not mean that we don’t have any more cash but just not in our hands at that instant. This will lead to us finding other sources and that can take time.
The same can be applied to an active business. A good working capital management means that the inventory is being converted into cash in a reasonable amount of time. Therefore, the business has enough amount of cash on hand to support daily operations and meet short-term obligations.
It is not just the business’s profit dependent on working capital but other elements as well. For example, short-term obligations include payment to suppliers, rents and debt due within a period of one year. Therefore, it is safe to say that working capital management affects the overall health of a business organization.
A significant thing to remember is that working capital may not only vary from industry to industry but among similar companies as well. The reason is the different policies regarding payment and timing of asset purchases. In some cases, the efforts of capital funding may also affect the working capital.
In case there are problems regarding the working capital, businesses may borrow working capital loans as part of working capital finance or inventory financing to support daily operations and meet short-term obligations.
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