Working Capital Management

Working capital has two components: current assets and current liabilities.

Current assets are important to businesses because they are the assets that are used to fund day-to-day operations and pay ongoing expenses. Depending on the nature of the business, current assets can range from barrels of crude oil, to baked goods, to foreign currency.

Current liabilities are bills that are due to creditors and suppliers within a short period of time. Normally, companies withdraw or cash current assets in order to pay their current liabilities.

Having explained both components, we can define the management of the capital as follows: Working capital management is an accounting strategy where the focus is on maintaining efficient levels of current assets and current liabilities, in respect to each other.

Cash is the lifeline of a company. If this lifeline deteriorates, so does the company's ability to fund operations, reinvest and meet capital requirements and payments. Take a simplistic case: a spaghetti sauce company uses $100 to build up its inventory of tomatoes, onions, garlic, spices, etc. A week later, the company assembles the ingredients into sauce and ships it out. A week after that, the checks arrive from customers. That $100, which has been tied up for two weeks, is the company's working capital. The quicker the company sells the spaghetti sauce, the sooner the company can go out and buy new ingredients, which will be made into more sauce sold at a profit. If the ingredients sit in inventory for a month, company cash is tied-up and can't be used to grow the spaghetti business. Even worse, the company can be left strapped for cash when it needs to pay its bills and make investments. Working capital also gets trapped when customers do not pay their invoices on time or suppliers get paid too quickly or not fast enough.

The better a company manages its working capital, the less the company needs to borrow. Even companies with cash surpluses need to manage working capital to ensure that those surpluses are invested in ways that will generate suitable returns for investors.

Working capital management ensures that a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses. Implementing an effective working capital management system is an excellent way for many companies to improve their earnings. The two main aspects of working capital management are ratio analysis and management of individual components of working capital.

A few key performance ratios of a working capital management system are the working capital ratio, inventory turnover and the collection ratio. With ratio analysis, we can conduct a quantitative analysis on the information in a company's financial statements. Ratios are calculated from current year numbers and are then compared to previous years, other companies, the industry, or even the economy to judge the performance of the company. 

Working capital ratio is used to measure a company's ability to recover operating costs from annual revenue. It is calculated by taking the company's total annual expenses (excluding depreciation and debt-related expenses) and dividing it by the annual gross income.

Inventory turnover is calculated as the ratio of cost of goods sold divided by the average inventory. The ratio should be compared against industry averages. A low turnover implies poor sales and, therefore, excess inventory. A high ratio implies either strong sales or ineffective buying. High inventory levels are unhealthy because they represent an investment with a rate of return of zero. It also opens the company up to trouble should prices begin to fall. A company's inventory turnover ratio is best seen in light of its competitors. In a given sector where, say, it is normal for a company to completely sell out and restock six times a year, a company that achieves a turnover ratio of four is an underperformer.

Collection ratio indicates the average number of days it takes a company to collect unpaid invoices. A high ratio indicates that the company is having problems getting paid for services or products. It is sometimes seasonally affected, rising during busy seasons and falling during the off-season. To account for seasonality, the average accounts receivable could be used instead. Insurance companies, for instance, receive premium payments up front before having to make any payments; however, insurance companies do have unpredictable cash outflow as claims come in. A big retailer like Wal-Mart has little to worry about when it comes to accounts receivable: customers pay for goods on the spot. Inventories represent the biggest problem for retailers; as such, they must perform rigorous inventory forecasting or they risk being out of business in a short time. Manufacturing companies, for example, incur substantial upfront costs for materials and labor before receiving payment. Much of the time they eat more cash than they generate.

Depending on the analysis results, the management can identify areas of focus such as inventory management, cash management, accounts receivable and payable management.

A vivid example of a successful working capital management strategy is by Computer giant Dell. Dell bolstered its shareholder value by focusing entirely on working capital management. The company's world-class supply-chain management system ensures that the number of days that a company takes to collect payment after making a sale stays low. Improvements in inventory turnover increase cash flow, leaving Dell with more cash on the balance sheet to distribute to shareholders or fund growth plans.

In conclusion, cash is king. How well a company handles its cash indicates the company's health in present and the future and opens it up for a rigorous evaluation of its potential value to the owners, i.e., the shareholders.