Working capital is the capital that a business uses to run and manage its regular operations. It helps companies make routine payments and ensure the smooth performance of business operations.
What is Working Capital Management?
Working capital management is defined as the process through which a company plans for utilizing its current assets and liabilities in the best possible manner to ensure operational effectiveness.
Working capital management allows organizations to maintain cash flows and lets them meet short-term targets, while also factoring in unexpected costs and unlocking cash that’s often tied up on the balance sheet.
How to Calculate Working Capital
The formula for calculating working capital is as follows:
Working Capital = Current Assets – Current Liabilities
Current assets are all assets that a company can convert into cash within the next year (12 months). These are generally quite liquid, often including accounts receivables and cash-in-hand. Short-term investments and available inventory are also classified under current assets.
Current liabilities are obligations that the company has to pay off within the next 12 months, including accounts payables and any debt payments that become due in this period. Companies often conduct ratio analysis for working capital management.
Key Components of Working Capital Management
Working capital management can be further divided into several key components:
1. Manage Liquidity
Proper liquidity management ensures that the organization has enough cash resources to address its regular business needs. It is also significant because it affects a company’s financial health, which can contribute to its success or failure.
If a greater amount of a company’s assets are tied up in illiquid assets, it might find it difficult to maintain effective cash flows or pay its short-term debts.
2. Manage Account Receivable
Accounts receivables are balances that debtors have to pay to the company. The amount becomes due when goods or services are delivered to a customer, but haven’t yet been paid for.
If a company finds it difficult to receive cash from its debtors, it may suffer from cash flow problems. The collection ratio is often used to calculate the average time it takes for a company to receive payment after a credit sale is made.
3. Manage Account Payable
Accounts payable refers to money due and owing by a company to its vendors, shown as an obligation on a company’s balance sheet.
Managing accounts payable is very important for maintaining effective working capital. Late payments could result in penalties or fines, and can damage a company’s credit ratings too. In some cases, non-payment could lead to mandatory liquidation of assets to pay off creditors.
Managing accounts payable and making sure payments are made on time is a key component of working capital management.
4. Managing Short-Term Debt
Managing short-term financing, like liquidity management, should concentrate on ensuring that the organization has enough liquidity to monetize short-term operations without taking huge risks.
The efficient handling of short-term financing entails selecting the appropriate financing mechanism and sizing the funds made accessible throughout.
5. Managing Inventory
Inventory is a company’s main asset used to generate sales revenue.
Investors view stock turnover as a clear indicator of a company’s sales capacity, as well as its purchasing and manufacturing dependability. Low inventory levels indicate that the company is at an increased risk of losing sales, whereas excessively high inventory levels may indicate inefficient use of working capital.
How to Improve Working Capital Management
Accelerating the cash conversion cycle can help a company’s working capital position, but it may have unintended consequences. For instance, withholding payments to suppliers may improve your cash position, but will affect your relationship with suppliers.
This may hurt your relationships with suppliers and could even make it difficult for cash-strapped suppliers to fulfill your orders on time.
As a result, efficient working capital management entails taking initiatives to strengthen the company’s working capital position while preventing negative consequences elsewhere in your supply chain. It often requires companies to strike a balance between liquidity and profitability.
Working Capital Management Objectives
Appropriate working capital management ensures that the firm always has enough cash to support its short-term operational expenses and debt obligations. It also facilitates the smooth functioning of the business and can help boost earnings and profitability.
Moreover, working capital management initiatives may have multiple objectives, such as:
1. Smooth Operating Cycle of Working Capital
The process of acquiring raw materials and converting them into cash should be smooth and straightforward. To effectively manage the operating cycle, consider these limitations:
- The raw material should be ordered from reliable vendors.
- All production requirements should be in place ahead of schedule.
- Finished goods should be sold as soon as they are manufactured and stocked.
- Accounts receivable should be collected on time.
- Accounts payable should be paid as soon as they become due.
- When cash is needed, it should be readily available.
2. Maintaining Optimum Working Capital
Companies need to maintain a balance for effective working capital management. Higher working capital broadly translates to greater efficiencies, and is used as an indicator for growth.
3. Meeting Debt Obligations
Working capital management should always make sure that the company has more than enough liquidity to meet its short-term commitments, which can be accomplished by collecting payments from customers quicker or by prolonging supplier payment terms.
4. Fueling Business Growth
If your company’s assets are encumbered by poor inventory control or accounts payable practices; it’s often difficult to grow. Effective working capital management focuses on minimizing the cost of spent capital, while maximizing returns on current investments.
This ultimately fuels business growth and allows companies to function more efficiently in the long run.
5. Improving Capital Performance
Another goal of working capital management is to enhance the utilization of capital usage, whether by lowering capital costs or increasing capital returns.
The former can be accomplished by unlocking cash on the balance sheet to reduce the need for debt.
Working Capital Management in a Nutshell
Working capital management represents the relationship between a firm’s short-term assets and its short-term liabilities. It aims to ensure that a company can afford its day-to-day operating expenses while also investing the company’s assets in the most successful direction possible.
Working capital management is possible by opting for modern solutions to create efficiency in the procurement and AP departments. This helps unlock cash that’s tied up on the balance sheet.
SoftCo Procure-to-Pay is a comprehensive solution for automating the entire finance process, from procurement until payment. It gives finance leaders a detailed oversight regarding procurement operations, allowing them to identify key opportunities for cost savings.
Transform Your Payments Process with SoftCoPay
SoftCoPay provides a centralized, secure channel for all vendor payments through one single payment file. The seamless process, from receipt of invoice to vendor payment, delivers control and transparency with straightforward reconciliation through the ERP and a fully auditable payment process. SoftCoPay is part of the SoftCo ecosystem and includes dashboards that provide comprehensive reporting to simplify administration for both vendors and the AP team. SoftCoPay integrates seamlessly with the ERP and is bank agnostic.
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