Working capital management definition
/What is Working Capital Management?
Working capital management is the actions taken to maintain a sufficient amount of working capital to support a business, while minimizing the investment in this area. The core goal in working capital management is to ensure that there is always sufficient cash on hand to pay for liabilities as they come due for payment. Since there can be a high cost associated with the funding of working capital, there is an offsetting pressure to keep funding levels low. This latter goal is achieved by closely monitoring the turnover levels for accounts receivable, inventory, and accounts payable, and taking action when the turnover levels vary from expectations. An additional tool used to monitor working capital levels is the short-term and medium-term cash forecast, which tells management when unusually high or low cash levels are expected.
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Understanding Working Capital
Working capital is comprised of current assets and current liabilities, where current assets minus current liabilities equals the net amount of working capital. Within the current assets classification are cash, accounts receivable, and inventory. The main element of current liabilities is usually accounts payable. Accounts receivable and inventory are a use of cash, while accounts payable is a source of cash. Therefore, the goal of working capital management is to minimize accounts receivable and inventory, while maximizing accounts payable.
How to Minimize Working Capital
There are many ways to reduce a company’s investment in working capital. Consider the options noted below.
Alter Policy Decisions
Some management decisions can have a direct impact on the level of working capital. For example, offering customers excessive credit in order to generate more sales represents a cash investment in accounts receivable. Or, setting a 24-hour order fulfillment policy will require a business to maintain much higher inventory levels than usual, which also requires a cash investment. These investments can be altered by adjusting the underlying policies.
Require Customer Deposits
In cases where customized goods are being produced, require customers to pay the full amount of the billing before work begins. Doing so is reasonable, since the company cannot sell the goods anywhere else. This policy also eliminates the investment in accounts receivable.
Shorten Customer Payment Terms
Reduce the number of days that customers are allowed to wait before paying an invoice. While this approach can reduce the investment in receivables, it is hard to enforce and may drive customers toward competitors who offer more generous terms.
Tighten Credit
Impose a tougher review process on requests from customers for trade credit. Doing so will likely result in some low-quality customers being denied credit, but it will reduce the number of customers who are likely to pay late.
Monitor Inventory Usage Levels
Routinely compare on-hand inventory balances to usage levels, to see if there is any excess inventory on hand. If so, and there is no immediate prospect for selling the excess amounts, then several actions can be taken to dispose of it. One is to return it to suppliers, perhaps in exchange for paying a restocking fee. Another option is to offer customers a special deal on these items, to encourage their immediate sale. Yet another possibility is to immediately sell it off to a discounter at a deeply reduced price. These actions can quickly turn excess inventory into cash.
Avoid Early Supplier Payments
Closely monitor when payments are issued to suppliers, to ensure that payments are not made early. This can happen when invoice dates are incorrectly entered into the accounting system, or when suppliers pressure the payable staff to send them payments before the company is contractually obligated to do so.
Lengthen Supplier Payment Terms
Negotiate with suppliers to lengthen payment terms. Doing so delays the outflow of cash needed to pay for supplier invoices, which represents a source of cash. Do not unilaterally impose longer payment terms on suppliers, since this can annoy them to the point where they may no longer accept orders without an up-front payment.
Working Capital Management Ratios
Several ratios are available that can assist managers in overseeing working capital. They are the days sales outstanding, current ratio, and inventory turnover ratio. We explore all three measurements below.
Days Sales Outstanding
Days sales outstanding is used to determine the efficiency with which a business collects its accounts receivable. The formula is to divide accounts receivable by the annual revenue figure and then multiply the result by the number of days in the year. The formula is as follows:
(Accounts receivable ÷ Annual revenue) × Number of days in the year = Days sales outstanding
The outcome is really a function of not just how well the collections staff does its job, but also of how well the credit staff advances credit to customers. If the credit staff erroneously grants credit and the company is not paid, then the DSO figure can be quite long.
Current Ratio
One of the essential working capital measurements is the current ratio, which compares current assets to current liabilities. If the current assets figure is substantially higher than current liabilities, then a business should be able to settle its short-term obligations in a timely manner. A ratio of at least 2.0 is considered to be quite good.
A problem with the current ratio is that the inventory component can be quite difficult to liquidate. Therefore, if the inventory component comprises a large proportion of current assets, it is quite possible that a business will have a hard time settling its obligations on time, because it cannot come up with the necessary cash on short notice.
Inventory Turnover Ratio
An additional working capital measurement is the inventory turnover ratio. Inventory turns should be quite high, which means that a business can sell off its inventory within a short period of time. When this is not the case, inventory may become a liability, since it sequesters cash and may result in obsolete inventory write-offs.
Inventory turnover is calculated by dividing the cost of goods sold for the year by ending inventory. The cost of goods sold figure is used instead of sales, because the sales figure includes a markup that is irrelevant to the calculation, and artificially inflates the turnover figure. The formula is as follows:
Annual cost of goods sold ÷ Ending inventory = Inventory turnover
An excessively high inventory turnover ratio can indicate that a business does not have sufficient cash to pay for the inventory needed to run its operations. When this is the case, the firm will probably not be able to maximize its sales.
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