Last Updated on October 12, 2023
When it comes to your company’s finances, few practices are more important than working capital management. By understanding the definition of working capital management and learning effective working capital solutions, you can improve the efficiency and financial stability of your business.
Here’s a closer look at how you can turn working capital management into a strength for your business.
What is Working Capital?
To understand working capital management, it’s important to first understand the meaning of working capital.
Working capital is a term that describes a business’s operating liquidity. Your net working capital is measured by adding up the total value of your business’s short-term assets, and then subtracting the total of its short-term liabilities.
Your net working capital essentially tells you if your business is able to meet its financial obligations. Working capital is often used to forecast how well a company could deal with a market disruption or sales decrease based on its asset to liability ratio, and to provide a current snapshot of its overall health.
What Is Working Capital Management?
In its broadest sense, working capital management is a company’s process for ensuring that it is using its financial resources effectively. It involves monitoring and managing all of the company’s assets and liabilities (including inventory, cash, and accounts receivable and payable) in an effort to ensure the company has sufficient cash flow.
The Importance of Good Working Capital Management
Understanding how to manage working capital is an essential part of helping your company have enough cash flow to cover its operating expenses. It gives you a comprehensive snapshot of your short-term assets and liabilities, which can give you a better understanding of your company’s overall financial health.
Working capital management helps you understand how to use your assets effectively — so that your funds aren’t locked into assets that can’t be easily liquidated for cash when necessary. Efficient working capital and cash flow management ensures your company is able to carry out its day-to-day operations, and even identify strategies to improve profitability.
Working Capital Management Strategies and Techniques
Understanding how much working capital you need is an important factor in defining the working capital management techniques and strategies that will work best for your business. While you should strive to have a positive working capital, there isn’t necessarily a best approach. Rather, several approaches can help you keep working capital where you want it to be.
The right strategy for managing capital can vary based on your collections and payment policies, the stage your business is in (as working capital needs can vary between new and established companies), efforts to raise working capital, and more.
No. 1: The Conservative Approach
To minimize risk, some companies take a more conservative approach to managing working capital. They try to maintain a high level of liquid assets to ensure they always have a positive margin in comparison to their existing liabilities. These companies may forgo certain investment opportunities in an effort to minimize financial risk.
While this reduces the likelihood of encountering cash flow problems, it does limit a company’s potential for increasing its profitability by not using those extra assets more productively. Reduced sales efficiency could put you behind competitors. However, this could be beneficial for organizations that are concerned about encountering short-term cash shortages due to industry volatility or being in a seasonal business. And of course, there is less risk for default and bankruptcy, even in cases of financial emergency.
No. 2: The Aggressive Approach
To increase profitability, many companies take a more aggressive approach to working capital management. While they try to maintain a positive assets- to- liabilities ratio, they carry a much lower level of liquid assets than more conservative companies. They put more money to work to speed up their business cycle and increase total revenue. This sometimes results in organizations cutting unnecessary supplies, tightening inventories, and stretching out repayment obligations.
By putting money “to work” in a more aggressive manner, such businesses can increase their profits at a much faster rate than if they took a conservative approach. However, with minimal liquid assets, companies expose themselves to much greater risk, especially if sales drop or another unexpected setback takes place. Some even experience shortages and lost sales because of being too aggressive in tightening their inventory. The more aggressive you become, the greater the risk for defaulting on business loans.
No. 3: The Moderate Approach
As a business becomes more established, it may be wise to seek a balanced, moderate approach between conservative and aggressive working capital strategies. With this strategy, the goal is to strike a balance between growing revenue and minimizing financial risks. You won’t necessarily maintain as many liquid assets as you would with a more conservative strategy, but you’ll definitely give yourself more breathing room than with an aggressive strategy.
With a moderate approach, you can also adjust your strategy to become more conservative or aggressive as needed during different periods, while maintaining general guidelines or boundaries to keep your organization from ever trending too far in one direction or the other.
How to Analyze Working Capital
The goal of any working capital analysis is to gauge whether you have positive working capital — or in other words, if your assets are greater than your liabilities, giving you enough liquidity to meet all essential financial obligations such as payroll and rent.
The simplest way to analyze or measure your working capital is to take the total value of your short-term assets and subtract the value of your short-term liabilities. You want this number to be in the positive — and if it’s not, you’ll likely need to look into working capital financing options like a short-term loan or invoice factoring to cover your obligations.
A cash flow statement can be a helpful resource when analyzing your working capital, as it is specifically designed to track cash movement. This measures your actual liquid assets, rather than including other non-cash factors that don’t necessarily qualify as short-term or liquid assets.
Working Capital Management Ratios
While subtracting your total short-term liabilities from the total value of your short-term assets can give you a full dollar amount of your available working capital, this isn’t the only way you can use working capital to measure the financial health of your company. There are several types of working capital ratios that can be used to provide an even more comprehensive picture of your business’s current financial well-being.
Working Capital Ratio
Also known as the current ratio, the working capital ratio is determined by dividing your total short-term assets by your total short-term liabilities. The goal of this measurement is to ensure that your business can pay all of its short-term financial obligations that are due within one year. To measure the current working capital ratio, add the total of your cash, cash equivalents, receivables, and inventory, and divide that total by your current liabilities.
Generally speaking, most businesses should have a working capital ratio of 1.5-2.0, meaning they have 1.5 to 2 times as many assets as they do liabilities. If your working capital ratio is less than one, it means you have more debts than cash assets. To meet your financial obligations, you may need to obtain alternative financing or sell some long-term assets to cover the shortfall.
Contrarily, a working capital ratio that is greater than 2.0 may indicate that your company is being too conservative in its approach to working capital management. Failure to invest additional assets in other areas could result in lost opportunities for greater growth.
Average Collection Period Ratio
The average collection period ratio is an important measurement that can help you improve your overall working capital management. It helps you determine the average amount of time it takes to receive cash for accounts receivables. In other words, this ratio measures the average number of days it takes for your clients to pay their outstanding invoices. This measurement is especially important when invoices make up a large portion of your working capital.
To measure your average collection period ratio, start with the number of days in the period of your credit policy. For example, if you use net 15 payment terms, your “days in period” number should be 15. Multiply this number by the average accounts receivable.
Average accounts receivable can be determined using your income statements. Add the total accounts receivables at the beginning of the collection period to the total accounts receivables at the end of the collection period. Divide that total in half to determine the average accounts receivable for your measurement.
After you multiply the days in period by the average accounts receivable, you’ll divide that total by your net credit sales for the period. This gives you your average collection period ratio.
(Days in Period X Average Accounts Receivable) ÷ Net Credit Sales = Average Collection Period Ratio
You can compare the average collection period ratio to how many days you offer in your current credit terms. If you offer net 15 payment terms, your average collection period should be 15 days or less. If it is more than 15 days, it means that most of your invoices are paid late, which can create significant working capital issues. You can also compare this number to the previous year’s collection period ratio to determine whether collections are getting better or worse.
The cash ratio is similar to the current ratio/working capital ratio, but with an important difference: it only counts cash and cash equivalents as your short-term assets. This measurement helps determine if your company can pay off its short-term debts in a worst-case scenario, such as insolvency.
Generally speaking, the cash ratio is not used as often because most companies do not keep large amounts of cash on hand. Reinvesting leftover funds will deliver a much higher return than “sitting on” available cash. Because of this, the cash ratio should generally fall between 0.5 and 1, since a significant portion of business assets should be held in non-cash accounts.
Working Capital Management Solutions and Software
Our working capital calculator is a simple and free tool that lets you quickly calculate both your total net working capital and your current working capital ratio, based on the totals of your current assets and current liabilities.
Of course, you’ll need to accurately add up your total assets and liabilities for these measurements to provide useful information. Working capital management software can help you track and manage your short-term assets and liabilities so you can have a better understanding of your current cash flow. By setting up automated tracking of your assets and liabilities, and effectively tracking invoices through CRM tools, you can have a clearer understanding of your overall financial picture so you can make better informed decisions regarding your working capital.
With software tools to help automate your ability to track assets, liabilities, cash flow, and more, you’ll have everything you need to make quick decisions that reflect your current liquidity. Combining accurate information with a strong understanding of working capital management is key to ensuring a healthy and stable financial future for your business.
Working Capital Management FAQs
What does WCM mean in business?
WCM stands for working capital management — or a company’s processes for monitoring and managing its short-term assets and liabilities to ensure it has sufficient cash flow to meet its financial obligations.
What is the difference between working capital and cash flow?
Working capital and cash flow are related, but they describe two different things. Cash flow measures how much money is going in or out of your company during a given period (such as a week or quarter). It tells you if you are earning more money than you’re spending during that time.
Net working capital shows the difference between your total assets and liabilities. This extends beyond cash, as your assets can include investments as well as inventory or even business equipment. Liabilities can include all accrued expenses, including loans and outstanding accounts.
What is the difference between working capital and liquidity?
Liquidity is a measurement of whether a company is able to access money to pay its debts and other financial obligations. Working capital helps measure the difference between short-term assets (such as cash and assets that can be sold for cash) and short-term liabilities. If a company has positive working capital, that means it has sufficient liquidity to cover its expenses.
What are some examples of working capital management?
In its broadest sense, working capital management refers to any activity that allows your team to analyze your working capital. This could include measuring your current working capital ratio and comparing and analyzing the difference between this year and last year. This would allow you to make a comparison of whether your company’s overall financial health has changed over time, and determine if any adjustments need to be made.
Michael McCareins is the Content Marketing Associate at altLINE, where he is dedicated to creating and managing optimal content for readers. Following a brief career in media relations, Michael has discovered a passion for content marketing through developing unique, informative content to help audiences better understand ideas and topics such as invoice factoring and A/R financing.