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
- Gross Working Capital
- Net Working Capital
B. Based on time period
- Fixed Working Capital
- 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
- Unless it is specified otherwise, the calculation of stocks of the finished products and debts should be made at cost.
- 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.
- 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.
|Current ratio||Current Assets/ Current Liabilities||Also known as the Working Capital Ratio and measures the short-term financial health of a company.|
|Acid Test Ratio/ Quick Ratio||Liquid Assets/Current Liabilities||Measures 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 Liabilities||Includes 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 Ratio||Cost 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|