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Working Capital Management Explanation

Working capital management is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to the best effect.

The primary purpose of working capital management is to ensure the company has sufficient funds at its disposal to meet short-term operating costs and short-term debt obligations. A company's working capital consists of current assets minus current liabilities.

The current assets for a company are any items that can be converted into cash within 12 months. These include the most liquid items held by a business. Current assets include cash, accounts receivable, inventory, and short-term investments. Current liabilities are any obligations due within the coming 12 months, which include operating expenses and long-term debt payments.

Working capital management is the process of monitoring cash flow, current assets, and current liabilities in order to optimize an organization’s use of liquid resources. Working capital management helps maintain the smooth operation of a company's net operating cycle, also known as the cash conversion cycle (CCC).

Companies often use their earnings and profitability for benefit of the company, but improvements can be made by improving their working capital. One aspect of management of working capital is inventory management, which includes the best practices for maintaining an accurate supply. Moreover, accounting for transactions between customers and the company results in accounts receivables on one hand, while paying off those same debts with cash leads to accounts payables on the other.

The objectives of working capital management are to ensure the company has enough cash on hand, minimize the cost of money spent in operations, and maximize the return on asset investments.

Working Capital Management Ratios

There are three ratios that are important in working capital management: The working capital ratio or current ratio; the collection ratio, and the inventory turnover ratio.

Current Ratio (Working Capital Ratio)

One way to analyze a company's financial health is by examining its working capital ratio, which divides the current assets of the company from its current liabilities.

Even though numbers vary by industry, a working capital ratio below 1.0 generally indicates that a company is having trouble meeting its short-term obligations. That is, the company's debts due in the upcoming year would not be covered by its liquid assets.

A working capital ratio higher than 2.0 may indicate a lack of efficient management of finance or unsecured financing. A low ratio could be the result of inadequately utilizing your assets to increase revenues, which leads to high expenses and a corresponding need for more cash to keep operations afloat.

Collection Ratio

The collection ratio identifies efficiency in how a company handles its accounts receivables. The number of days that pass in an accounting period multiplied by the average amount owed per customer then divided by total sales equals the collection ratio.

The collection ratio calculates how long it takes a company to receive payment on credit sales. If customers are fast in paying their bills and the billing department is efficient, the company's collection ratio will be lower. A low collection ratio indicates an easy flow of cash for the business.

Inventory Turnover Ratio

One of the final elements of working capital management is inventory management. A company needs to have enough and not too much inventory on hand in order to maximize efficiency while maintaining a high level of adequate funds.

A company's balance between inventory and revenue is measured using the inventory turnover ratio, calculated as revenues divided by inventory cost. When compared to other companies in its industry, a low percentage indicates that the firm has an excessive amount of inventory while a high percentage suggests that it needs to keep up with demand for its products.

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