The analysis of the current assets and liabilities of an organization is called working capital management. This makes it possible for the effective operation of the company. It is essential to look after the current assets and the current liabilities of the company. This makes sure you have enough cash flow to meet your short-term needs, such as its daily expenses and other payments.

Working capital management aims to assist organizations in making optimal use of current assets and maintaining adequate cash flow to achieve short-term goals and commitments. Efficient management of working capital helps companies to free up cash that might have been blocked. Consequently, they may be able to minimize their reliance on external financing, expand their operations, fund mergers, and acquisitions, and engage in research and development.

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Every company’s health depends on its ability to manage working capital, yet doing so properly is difficult. There are a lot of expenses that may occur. Some may be expected, and others may be unexpected. To meet all these expenses, there is a need to maintain cash in hand at all times. Not only this but also make the best use of the funds that are available to you. Accounts payable, accounts receivable, inventory, and cash needs to be managed effectively to achieve this.

Calculation of Working Capital

The working capital of a company equals current assets minus current liabilities. 

  • Working Capital = Current Assets – Current Liabilities

Current assets can be converted into cash within 12 months. Some of the examples of current assets are cash, account receivables, inventory, and short-term investments. 

Ratios Used in Working Capital Management

Working capital management stands for several factors. These factors need to be analyzed to keep a watch on the company’s cash flow, working capital, and other operating expenses. In working capital management, there are three key ratios to consider, which are given below:-

Current Ratio- 

Current assets divided by current liabilities give us the current ratio. It is also called the working capital ratio. It’s an important measure of a company’s financial health since it shows how well it can satisfy short-term financial obligations. 

Working capital ratios of less than 1.0 are not acceptable. This is because it shows that a business is having difficulty fulfilling its short-term obligations. This indicates that the company’s obligations due in the following year would be insufficient to cover them. In such a situation, the firm may have to sell assets, secure long-term loans, or seek alternative forms of funding to meet its short-term debt commitments. 

This ratio should ideally be between 1.2 to 2.0. A ratio larger than 2.0, on the other hand, may suggest that the company is not effectively leveraging its assets to increase sales. A high ratio might suggest that the firm is not properly procuring funding or managing its operating capital.

Collection Ratio- 

The collection ratio shows how a firm handles its receivables. It is determined by multiplying the number of days in an accounting period by the average amount of outstanding accounts receivables and dividing it by the total net credit sales during that period.

The collection ratio calculation determines the average number of days a firm takes to obtain payment following a credit sales transaction. The collection ratio will be lower if a company’s billing department effectively collects attempts and customers pay their bills on time. The lower the ratio, the more efficient is the cash flow of the company.

Inventory Turnover Ratio- 

One of the essential components of working capital management is inventory management. It is crucial to keep the minimum inventory requirement to satisfy the customer needs as and when they arrive. Inventory management is the final component of working capital management. At the same time, excess inventory must not be kept; otherwise, working capital gets blocked in inventory. So, a balance is necessary to maintain a high level of working capital. The inventory turnover ratio is commonly used by businesses to determine how effectively that balance is maintained. 

The inventory turnover ratio is calculated as sales divided by inventory cost. It helps in knowing how quickly a company’s inventory is being sold and replenished. Compared to industry peers, a low ratio implies overly high inventory levels, while a high ratio indicates insufficient inventory levels.

Effective Management of the Working Capital

The time required to convert net current assets and liabilities into cash is the net operating cycle or cash conversion cycle.  Accelerating the Cash conversion cycle might help a company’s working capital, but it can also have unintended repercussions. 

Your accounts payable is also your suppliers’ accounts receivable, thus paying suppliers later may improve your working capital at the expense of your suppliers’. 

As a result, effective working capital management entails adopting actions to enhance the company’s working capital situation without causing ripple effects across the supply chain. This could entail reducing the days taken by the company’s customers to pay their invoices by implementing more efficient invoicing systems, allowing consumers to receive bills sooner. Alternatively, it might imply implementing an early payment scheme that allows your suppliers to get paid sooner than they would otherwise. 

Solutions for Effective Management of Working Capital 

Companies may use various tools to help them manage their working capital, both internally and with their suppliers. Some of these include: –

Invoicing Using Electronic Means-

Companies can gain working capital benefits by submitting invoices electronically. You can decrease the chance of mistakes, automate tedious procedures, and ensure that your clients receive your bills as quickly as possible by simplifying the invoicing process – which may mean you get paid sooner. Companies can use electronic invoice submission techniques to automatically convert purchase orders into invoices or submit large invoices via system-to-system connectivity. 

Forecasting Cash Flow-

Companies may plan for anticipated cash shortages and better use surpluses by projecting future cash flows, such as payables and receivables. Your working capital management decisions will be better informed if you can adequately forecast your future cash flows.

Finance for Supply Chains- 

Supply chain financing, often known as reverse factoring, allows purchasers to give early payment to suppliers through one or more third-party funders. Suppliers may improve their cash flow by getting paid sooner and at a lower cost of capital, while buyers can keep their working capital by paying according to agreed-upon payment terms.

Discounting That Changes Over Time- 

Buyers can also utilize dynamic discounting to give early payments to suppliers. This is done by giving early payment discounts. Suppliers are allowed additional discounts if they pay within a specified period. This is to attract them so that they pay early. Furthermore, it enables buyers to earn a lucrative risk-free return on their surplus funds.

Flexible Funding- 

This makes it simple for buyers to switch between supply chain finance and dynamic discounting models. Businesses may react to shifting working capital demands while still supporting their suppliers in this manner.

The Bottom Line –

Working capital management may help a firm increase its revenues and profits by using its resources better. All businesses require cash flow for their everyday needs. This is ensured by working capital management. Working capital management is the report card of a company’s financial health. Therefore, you can upskill your skill sets by engaging in online management courses from reputed organizations like Great Learning to efficiently handle working capital management. 

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