Are you aware of the challenges companies face from needing to grasp working capital management fully? Are you also aware that your business could remain stagnant unless you fix the issue of managing your daily working capital?
Although this concept may appear complex due to the interwoven components, it’s not a cause for alarm, as we’ll address its complexity shortly.
This guide is meant to help business owners understand working capital management and how it works. I’m sure you’re curious to unravel this seemingly complex subject matter, which is not even close to the complex.
What is Working Capital Management?
Working capital is what a company has left after subtracting its current liabilities from its current assets. Knowing this, we can now discuss what working capital management is.
It refers to how a company can manage its current assets and liabilities and effectively use these assets to service all forms of liabilities that they have.
The main idea behind managing working capital is so that a company can have sufficient cash to cover short-term operational expenses and debt. This is very important for every company that intends to avoid accumulating debt.
Furthermore, current assets here refer to those things a company can readily convert into cash within 12 months. These include fiscal cash, accounts receivable, inventory, and short-term investments.
Current liabilities, on the other hand, refer to all the compulsory debts a company must service within 12 months
Components of Working Capital Management
In tackling the issue of working capital management, there are some components that we must consider. Just like the structure of a house is made of building blocks, so are the components of working capital management.
Let’s examine what they are as we uncover the technicalities of working capital management:
1. Cash
Companies want to avoid getting to the point where they have no cash for expenses. So, they ensure that cash is always available to solve immediate liabilities. This is a very important component of the grand working capital management scheme.
Additionally, they must monitor their cash flow system outside the company. However, if or when there is neglect in this area, the company eventually suffers.
2. Receivables
Receivables refer to all the money a company receives from an external source. This includes the money customers receive through product sales based on the established payment policy.
In addition, a company must be able to manage the systems by which they collect these receivables to manage their working capital effectively.
3. Inventory
This refers to all products owned by a company that are in stock, and to manage their working capital, they take their inventory very seriously.
These inventories must be sold to have cash because any product they cannot sell at a set time becomes a liability. Additionally, they are aware of the loss they may incur when their products are not sold on time, which could hamper their cash flow.
Hence, to make quick sales and sustain the cash flow, they may reach out to customers to buy their products at a low price.
4. Payables
Payables refers to all the short-term payments a company makes, which may be to the company’s advantage because they exert a form of control here.
In addition, they can determine how soon they pay suppliers and other areas that need payment. Moreover, it also ensures that a company has some cash to use to solve its immediate need
Read also: Creating a budget for business success: A step-by-step guide
Types of Working Capital
As we’ve earlier established, working capital is simply the cash left after current liabilities have been subtracted from current assets.
Of these, there are a few types that every business must know and understand so that managing working capital becomes easy. Let’s take a look at them:
1. Permanent Working Capital
This type of working capital refers to the amount that must always be available for a company to run successfully. The minimum amount of resources must be available for the business to solve its short-term needs.
A further split of this type brings about the regular-permanent and the reserved-permanent working capitals.
While regular-permanent working capital deals with resources used for day-to-day operations, reserved-permanent working capital deals with resources kept in case of an emergency.
2. Gross Working Capital
This refers to the total amount of current assets a company has, excluding any short-term liabilities.
3. Net Working Capital
When a company calculates all their assets and liabilities and subtracts the total liabilities from the total assets, what they have is termed “net working capital.”
Why is it Important to Manage Working Capital?
The ultimate aim of working capital management for any business is to optimize the readiness of cash availability for its use.
Since working capital is the money left after removing current liabilities from current assets, companies can monitor and manage their cash flow effectively.
Also, delaying supplier payments allows businesses to keep cash on hand to efficiently pay for unforeseen cost
Working Capital Management Ratios
In the management of working capital, three types of ratios are relevant. The current or working capital ratio, the collection ratio, and the inventory ratio.
1. Current Ratio (working capital ratio)
How did they come up with this ratio? Well, it’s quite simple. This ratio can be obtained by simply dividing the current assets by the current liabilities of your company, respectively.
It would help if you referred to where I explained these terms earlier. After the division, if your value is less than 1.0, there’s a problem. The problem here is simple: you cannot service your current liabilities.
The alternative to this is that you either sell off some of your long-term assets or look for funding somewhere else.
On the other hand, and this one is better, if your value is between 1.0 and 2.0, it means your business is able to sort out its short-term liabilities effectively. While this is good, there’s a third side: when your current ratio exceeds 2.0, you have more cash available than you need.
Moreover, it will be better for your business to invest that excess cash towards increasing your assets, thereby boosting your working capital management.
2. Collection Ratio (Days Sales Outstanding)
Don’t let this term confuse you. The collection ratio, or days sales outstanding, or DSO, informs a company of how long it will take to collect the payment on sales that their customers owe them.
As a policy, some companies have different payment plans under which they collect payments from sales on credit. The collection ratio that a company calculates helps them effectively manage their accounts receivable.
How can I calculate the collection ratio for my business? It’s quite simple.
All you need to do is divide the average accounts receivable during a given period by the total value of credit sales during the same period and then multiply the result by the number of days in the period being measured.
Furthermore, to determine the average amount of the accounts receivable, you can take the average between the beginning and ending balances. Collection ratios can be done as often as monthly, quarterly, or yearly.
The main reason a company will calculate a collection ratio is to find ways to shorten the days to quickly get cash from their customers, which will help them effectively manage their working capital.
3. Inventory Turnover Ratio
Truth be told, every company wants to always have sufficient goods on hand that can readily meet the demands of their customers.
While I support this, it becomes a challenge when these goods have become excessive compared to demand and have lasted longer than expected.
Additionally, the inventory turnover ratio informs a business of how quickly they are able to convert their inventory into cash through sales and how quickly it is replaced.
Moreover, calculating the inventory turnover ratio is quite simple. All you need to do is divide the cost of goods sold by the average balance in the inventory.
If you realize a relatively low ratio, it implies that you have more inventory, and you may need to slow down on your production to avoid the risk of damaging goods.
On the other hand, if the inventory turnover ratio is relatively high, you’re also at risk of not being able to meet customers’ demands.
All in all, you must seek balance and a suitable turnover ratio for effective working capital management.
Limitations to Effectively Managing Your Working Capital
It is good enough that you have a solid working capital management system, but is it sufficient to help you manage your business’ finances? The answer is no.
There are limitations to working capital management. Even the best of these practices will not solve issues such as long-term business finances. As you can recall, working capital management deals with short-term assets and liabilities.
To be able to meet short-term needs, a company may have to sacrifice its long-term financial solution and health.
Another limitation of working capital management is the uncertainty of how the future of the business will turn out.
Different factors like changes in the economy, customer behaviour, and a disruption in the supply chain can affect how a company manages its working capital.
Lastly, working capital doesn’t address how a business will increase profitability. While it’s a good practice to manage working capital, the business may not see growth when there are no other strategies like sales, marketing, etc.
You’ll have to add other aspects to financial management to help you succeed.
Conclusion
As we’ve discussed from the onset, working capital management has the potential to help you understand what’s going on with your company’s assets and liabilities. This practice allows you to make cash available to run your business readily.
In addition, working capital management has been simplified enough for you to know exactly what to do with your working capital. Moreover, remember that you must find balance among all the working capital ratios, as they can deter or promote your efforts.
Understand that this practice is not absolute; therefore, you should be open to other ways to combine them to improve your business’ finances.
