Business owners are confronted with a wide range of tools and ratios that can help them effectively manage their business. One such tool is Working Capital management. This article will explain working capital and provide a few examples of how to apply a variety of techniques for managing working capital.
Working Capital defined: Working capital is the result obtained when subtracting current liabilities from current assets. A positive number is desired which indicates that there are more short-term assets available than short-term obligations. There are two components to working capital – current assets and current liabilities. Current assets generally include cash, accounts receivable and inventories. Current liabilities are more often composed of accounts payable, other payables such as sales and employee benefit taxes payable and short term debt including lines of credit and short term notes payable.
Working Capital management: A surplus of working capital is an important factor in minimizing risk for the company. Equally, if not more important, is cash availability. Effective management of working capital involves intentional strategies for investing in current assets and the selection of alternative methods of financing that investment. Of particular importance is the impact on cash availability.
Investment strategics abound. For example, while accounts receivable is part of current assets, increases in accounts receivable tie up cash. It is prudent to actively manage accounts receivable with emphasis on keeping days payable is small as possible without losing sales. Cash can also be invested into inventory. increases in inventory also tie up cash, limiting options. Management of inventory, keeping days sales in inventory as low as possible, can free up cash for other uses. Investment in non-current assets dilutes Working and ties up can on a long term basis and reduces working capital.
Financing strategy possibilities. Working capital is reduced by increases in current liabilities. However, financing of increases in current assets is frequently achieved by increase in accounts payable, lines of credit or short term notes. If increases in current assets are achieved by comparable increases in current liabilities. the result is little if any change in working capital. Although not recommended, one strategy to fund current assets could be to use long term debt as the financing vehicle. This strategy improves working capital since current assets is increased without a change in current liabilities.
Working capital is an important indicator of financial wellbeing. Because working capital may vary from day to day, business owners should monitor it on a daily basis.