Working capital is a critical aspect of any business for the smooth running of its operations and is an indicator of the financial health of a business.
Working capital is the money used to meet a business’ day-to-day operating expenses and short-term obligations (i.e. those due in the next 12 months). Working capital management is a strategy employed by businesses to ensure efficient utilization of current assets to cover current liabilities and to ensure effective business operations.
The optimal working capital ratio (i.e. current assets to current liabilities) is between 1.2 and 2. A ratio less than 1 is an indicator of future liquidity problems and management needs to act immediately. A ratio greater than 2 could be a sign that management is hoarding too much cash instead of investing to generate returns and enhance growth.
How Can Businesses Manage Their Working Capital?
- Managing Inventory – A higher net working capital can be achieved by reducing slow-moving inventory, increasing inventory turnover, and avoiding stockpiling.
- Managing Payables – Effective and efficient management of payables is a great factor in working capital management. It develops better relationships with vendors; avoids fines and penalties; and enables the business to negotiate better deals, payment terms, and discounts.
- Managing Receivables – A company should collect its receivables on time to increase the current assets of a company which in turn increases the working capital of the company and improves ability to meet obligations arising from operations.
- Managing Short-term Debt – Companies should select the appropriate capital structure and funding mechanisms to minimize the cost of capital and maximize the value of the company.
- Supply Chain Management – To help reduce unexpected expenditures and protect working capital a company should manage inventory levels, have a consistent supplier listing, be able to track supplier performance, and regularly negotiate better terms.
- Careful Control and Monitoring of Expenses – A company should have in place appropriate policies and procedures, budgets, and budgetary controls to help manage expenditure and ensure smooth functioning of the business.
References
- First Circle (2020). 15 Best Ways to Improve Your Working Capital https://www.firstcircle.ph/blog/best-ways-to-improve-working-capital
- Softco-Working Capital Management https://softco.com/glossary/working-capital-management/
- Corporate Finance Institute (CFI) (2020). Working Capital Management https://corporatefinanceinstitute.com/resources/knowledge/finance/working-capital-management/
