Have you ever wondered how a company manages its money and pays its bills? Working capital management is how companies are able to manage finances and continue operations.
What Is Working Capital Management?
Working capital management is the way a company manages the relationship between assets and liabilities in the short term. Simply put, working capital management is how a company manages its money for day to day operations as well as any immediate debt obligations. When managing working capital, the company has to manage accounts receivable, accounts payable, inventory, and cash.
The goal of working capital management is to have adequate cash flow for continued operations and have the most productive usage of resources.There are a few calculations we have to discuss in regards to working capital management. To calculate working capital, a company would take current assets and subtract current liabilities.Working capital efficiency is determined by calculating the working capital ratio.
This ratio is a key indicator in the company’s financial health. The working capital efficiency is calculated by taking current assets divided by current liabilities. If the result of the calculation is less than 1.
0, then it is taken as a sign that the company’s having financial issues. If the result of the calculation is greater than 1.0 but less than 2.0, then the company is in good financial health. If the calculation yields a result greater than 2.
0, then company may not be making an effective use of its assets.The next calculation we need to understand is receivables turnover. This is a calculation of how many times an account is created and collected during the reporting period. Receivables turnover is calculated by dividing the total revenue by average receivables. That was a long way to say how many times orders are being created and invoiced during the reporting period.The last calculation we need to understand for working capital management is the inventory turnover ratio. The inventory turnover ratio is calculated by costs of goods sold divided by the average inventory costs.
If the results are less than 1.0 then the company is not moving enough inventory.
Working Capital Management in Action
John is the CEO of Wookie Inc. and he is trying to determine what his working capital is to see if he can invest in a new technology.
Wookie Incorporated has current assets totaling 8.9M, and their current liabilities are 7.6M. John takes 8.9 minus 7.6 and the result is 1.
3M. John feels good about having 1.3M of available capital. He takes his calculations a little further to determine what the working capital effect is for Wookie Inc.
He takes 8.9 divided by 7.6 to get a ratio of 1.17.
With the calculations, John determines that the company is in good financial health, and he can invest in new technology.Ralph is the inventory manager for Lightsaber Incorporated. Ralph wants to determine his inventory turnover. Cost of goods sold is 300M, and the average inventory is 600M. The inventory turnover is .
5. Ralph determines that the company is holding too much inventory and scales back production.Steve is the finance manager for Link Meats, and he is trying to determine receivable turnover. The company has total revenue of 4M and are has average receivables of 4M. The company’s receivable turnover ratio is 1.0, which is good for the company.
Using the Data
Everything we learned so far is fairly easy to calculate and understand, but how do we use the data that we calculated and what is the goal? The goal is to have a positive cash flow, so the company can continue operations. Every company has to have a positive cash flow or else the company will eventually go bankrupt and close. The data that we calculate is used in forecasting cash flow to determine what the company can and cannot do in the future.
Working capital management is the way a company manages the relationship between assets and liabilities in the short term: that means how a company will continue to operate while paying short term debt that is coming due while covering operational expenses. To understand working capital management, a few calculations are needed.The first is to determine working capital, the difference between current assets and liabilities. Then, the company will need to determine the working capital ratio by dividing assets by liabilities.
If the ratio is below 1.0, then the company is having financial troubles, and it is desirable to be between 1.0 and 2.0.The next calculation is the receivable turnover, which is when the amount going out is divided by what is coming in. Again it is desirable to be between 1.0 and 2.
0. The last item to calculate is the inventory turnover ratio. This is the cost of goods sold divided by average inventory. The key is to keep this between 1.
0 and 2.0. If it is outside the parameters, changes need to be made.