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Working Capital Management – Applicability, Analysis & Ratios

Updated on: Jun 22nd, 2021


6 min read

Working capital management is the process of managing these short-term assets and liabilities to ensure the company has adequate liquidity to operate smoothly.

Relevance of Working Capital

The working capital ratio is crucial to creditors as it shows the liquidity of the company. The liabilities of current nature are paid with current assets like marketable securities, cash, and cash equivalents. The faster an asset can be converted into liquid cash, more likely that the company will be able to pay off its debts. When the current liabilities are exceeded by the current assets, the business will have ample capital for its daily operations.

In other words, it will have enough capital to work with. This ratio is a measure of a company’s short-term financial health and its efficiency. Anything that is below 1 is indicative of a negative W/C (working capital). While anything that is over 2 indicates that the company is not investing the excess assets. Most ideally this ratio should be between 1.2 and 2.0.  Another name for working capital is net working capital.

Working Capital = Current Assets – Current Liabilities

Measure the efficiency of working capital

Working capital efficiency can be measured by certain ratios. The working capital cycle and other working capital ratios are compared to other industry benchmarks or the company’s peers. Some of the measures used in estimating the efficiency of working capital management include current ratio, days of payables outstanding, days of inventory outstanding, days of sales outstanding, etc. Due to the small scale of operations in small business, liquidity tends to be in tight supply and investment in the area of working capital can be an issue.

Many small businesses are unable to fund their operating cycles with account payables and hence, have to rely on the cash that is generated through the internal sources like the owner, etc. if the working capital is managed efficiently, the business will be able to free up cash to pay debts or for reinvestments.

Working Capital can be divided into two main categories:

A. Based on capital

  1. Gross Working Capital
  2. Net Working Capital

B. Based on time period

  1. Fixed Working Capital
  2. Variable Working Capital

Importance of Gross Working Capital

Investments in current assets must not be either excessive or inadequate as it can threaten the production capacity and the solvency of the company. It also undermines the profit of the business.

Importance of Net Working Capital

Net working capital is crucial for maintaining a position of liquidity and to make sure that current assets exceed current liabilities. This is also the number that gives the creditor a clear picture into the financial soundness of your business.

Estimating the working capital of your business

  1. Unless it is specified otherwise, the calculation of stocks of the finished products and debts should be made at cost.
  2. Profits are to be ignored when calculating the working capital as profits may or may not used as working capital and even in the scenario of it being used the amount will be reduced due to taxes, dividends, etc.
  3. Unless mentioned otherwise, take into consideration the 100 percent value of WIP.

Techniques to analysis working capital

There are several methods to conduct a working capital analysis, these include:

A. Ratio Analysis

This is a simple arithmetic view of the relationship between numbers. It is used to measure the short-term liquidity of the firm.

Liquidity Ratio

Current ratioCurrent Assets/ Current LiabilitiesAlso known as the Working Capital Ratio and measures the short-term financial health of a company.
Acid Test Ratio/ Quick Ratio Liquid Assets/Current LiabilitiesMeasures if an asset can be liquidated to cash in a short period of time without the loss of value.
Cash Position Ratio/ Absolute Liquid Ratio[(cash & Bank) + short-term securities]/Current LiabilitiesIncludes cash in hand and that in the bank and the temporary investments including marketable securities. This ratio must ideally be 50 percent.

Inventory Turnover Ratio = Cost of Goods Sold/Average Inventory at Cost

When the cost of goods sold is not known one may look at the following numbers:  

Inventory Turnover RatioCost of Goods Sold/Average Inventory at Cost When the cost of goods sold is not known one may look at the other formulas
Net Sales/Average Inventory at Cost
Cost of Goods Sold / Average Inventory at Selling Price

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Quick Summary

Working capital management ensures liquidity for daily operations. The working capital ratio shows liquidity; current assets meet liabilities efficiently. Efficiency is key for small businesses; ratios like current, payables, inventory outstanding, and sales outstanding are used. Gross and Net Working Capital are crucial for a company's solvency and financial soundness. Techniques like ratio analysis are used to measure working capital health.

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