WORKING CAPITAL MANAGEMENT-CHAPTER 7 OF MY BOOK ENTITLED INVENTORY MANAGEMENT, METHODS,TECHNIQUES, TYPES AND BENEFITS PUBLISHED ON AMAZON.

Working capital management is a critical component of inventory management.It is a business strategy designed to ensure that a company operates efficiently by monitoring and using its current assets and liabilities to their most effective use. ?The efficiency of working capital management can be quantified using ratio analysis. Again,manufacturing organizations are conscious of their working capital cycle which should how all the current assets turn into cash within one year.The current assets include debtors , receivables,inventory of finished goods, inventory of raw materials,work in progress, prepayments etc.

Understanding Working Capital Management

The primary purpose of working capital management is to enable the company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations. A company's working capital is made up of its current assets minus its current liabilities.

Current assets include anything that can be easily converted into cash within 12 months. These are the company's highly liquid assets. Some current assets include cash, accounts receivable, inventory, and short-term investments. Current liabilities are any obligations due within the following 12 months. These include accruals for operating expenses and current portions of long-term debt payments.

Working capital management monitors cash flow, current assets, and current liabilities using ratio analysis, such as working capital ratio, collection ratio, and inventory turnover ratio.

Main Components of Working Capital Management

Certain balance sheet accounts are more important when considering working capital management. Though working capital often entails comparing all current assets to current liabilities, there are a few accounts more critical to track.

Cash

The core of working capital management is tracking cash and cash needs. This involves managing the company's cash flow by forecasting needs, monitoring cash balances, and optimizing cash inflows and outflows to ensure that the company has enough cash to meet its obligations. Because cash is always considered a current asset, all accounts should be considered. However, companies should be mindful of restricted or time-bound deposits.

Receivables

To manage capital, companies must be mindful of their receives. This is especially important in the short-term as they wait for credit sales to be completed. This involves managing the company's credit policies, monitoring customer payments, and improving collection practices. At the end of the day, having completed a sale does not matter if the company is unable to collect payment on the sale.

Payables

Payables in one aspect of working capital management that companies can take advantage of that they often have greater control over. While other aspects of working capital management may be out of the company's hands (i.e. selling goods or collecting receivables), companies often have a say in how they pay suppliers, what the credit terms are, and when cash outlays are made.

Inventory

Companies primary consider inventory during working capital management as it may be most risky aspect of managing capital. When inventory is sold, a company must go to the market and rely on consumer preferences to convert inventory to cash. If this cannot be completed in a timely manner, the company may be forced to have short-term resource stuck in an illiquid position. Alternatively, the company may be able to quickly sell the inventory but only with a steep price discount.

Types of Working Capital

In its simplest form, working capital is just the difference between current assets and current liabilities. However, there are many different types of working capital that each may be important to a company to best understand its short-term needs.

• Permanent Working Capital: Permanent working capital is the amount of resources the company will always need to operate its business without interruption. This is the minimum amount of short-term resources vital to operations.
• Regular Working Capital: Regular working capital is a component of permanent working capital. It is the part of the permanent working capital that is actually required for day-to-day operations and makes up the "most important" part of permanent working capital.
• Reserve Working Capital: Reserve working capital is the other component of permanent working capital. Companies may require an additional amount of working capital on hand for emergencies, seasonality, or unpredictable events.
• Fluctuating Working Capital: Companies may be interested in only knowing what their variable working capital is. For example, companies may opt into paying for inventory as it is a variable cost. However, the company may have a monthly liability relating to insurance it does not have the option to decline. Fluctuating working capital only considers the variable liabilities the company has complete control over.
• Gross Working Capital: Gross working capital is simply the total amount of current assets of a business before considering any short-term liabilities.
• Net Working Capital: Net working capital is the difference between current assets and current liabilities.

?Managing Working Capital

Working capital management can improve a company's?cash flow management and earnings quality through the efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivable and accounts payable.?

Working capital management also involves the timing of accounts payable (i.e., paying suppliers). A company can conserve cash by choosing to stretch the payment of suppliers and to make the most of available credit or may spend cash by purchasing using cash—these choices also affect working capital management.

The objectives of working capital management, in addition to ensuring that the company has enough cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and maximizing the return on asset investments.

Working Capital Management Ratios

Three ratios that are important in working capital management are the working capital ratio (or current ratio), the collection ratio, and the inventory turnover ratio.

Current Ratio (Working Capital Ratio)

The working capital ratio or current ratio is calculated by dividing current assets by current liabilities. The current ratio is a key indicator of a company's financial health as it demonstrates its ability to meet its short-term financial obligations.2

A working capital ratio below 1.0 often means a company may have trouble meeting its short-term obligations. That is because the company has more short-term debt than short-term assets. In order to pay all of its bill as they come due, the company may need to sell long-term assets or secure external financing.

Working capital ratios of 1.2 to 2.0 are considered desirable as this means the company has more current assets compared to current liabilities. However, a ratio higher than 2.0 may suggest that the company is not effectively using its assets to increase revenues. For example, a high ratio may indicate that the company has too much cash on hand and could be more efficiently utilizing that capital to invest in growth opportunities.

Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO), is a measure of how efficiently a company manages its accounts receivable. The collection ratio is calculated by multiplying the number of days in the period by the average amount of outstanding accounts receivable. Then, this product is divided by the total amount of net credit sales during the accounting period. To find the average amount of average receivables, companies most often simply take the average between the beginning and ending balances.

The collection ratio calculation provides the average number of days it takes a company to receive payment after a sales transaction on credit. Note that the days sales outstanding ratio does not consider cash sales. If a company's billing department is effective at collecting accounts receivable, the company will have quicker access to cash which is can deploy for growth. Meanwhile, if the company has a long outstanding period, this effectively means the company is awarding creditors with interest-free, short-term loans.

Inventory Turnover Ratio

Another important metric of working capital management is the inventory turnover ratio. To operate with maximum efficiency, a company must keep sufficient inventory on hand to meet customers' needs. However, the company also needs to strive to minimize costs and risk while avoiding unnecessary inventory stockpiles.

The inventory turnover ratio is calculated as cost of goods sold divided by the average balance in inventory. Again, the average balance in inventory is usually determined by taking the average of the starting and ending balances.

The ratio reveals how rapidly a company's inventory is being used in sales and replaced. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, meaning a company may want to consider slowing production to ease the cost of insurance, storage, security, or theft. Alternatively, a relatively high ratio may indicate inadequate inventory levels and risk to customer satisfaction.3

Working Capital Cycle

In addition to the ratios discussed above, companies may rely on the working capital cycle when managing working capital. Working capital management helps maintain the smooth operation of the net operating cycle, also known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net current assets and liabilities into cash. The working capital cycle is a measure of the time it takes for a company to convert its current assets into cash, or:

Working Capital Cycle in Days = Inventory Cycle + Receivable Cycle - Payable Cycle ?

The working capital cycle represents the period measured in days from the time when the company pays for raw materials or inventory to the time when it receives payment for the products or services it sells. During this period, the company's resources may be tied up in obligations or pending liquidation to cash.

Inventory Cycle

The inventory cycle represents the time it takes for a company to acquire raw materials or inventory, convert them into finished goods, and store them until they are sold. During this stage, the company's cash is tied up in inventory. Though it starts the cycle with cash on hand, the company agrees to part ways with working capital with the expectation that it will receive more working capital in the future by selling the product at a profit.

Accounts Receivable Cycle

The accounts receivable cycle represents the time it takes for a company to collect payment from its customers after it has sold goods or services. During this stage, the company's cash is tied up in accounts receivable. Though the company was able to part ways with its inventory, it's working capital is now tied up in accounts receivable and still does not give the company access to capital until these credit sales are received.

Accounts Payable Cycle

The accounts payable cycle represents the time it takes for a company to pay its suppliers for goods or services received. During this stage, the company's cash is tied up in accounts payable. On the positive side, this represents a short-term loan from a supplier meaning the company is able to hold onto cash even though they have received a good. On the negative side, this creates a liability that needs to be managed.

Limitations of Working Capital Management

With strong working capital management, a company should be able to ensure it has enough capital on hands to operate and grow. However, there are downsides to the approach. Working capital management only focuses on short-term assets and liabilities. It does not address the long-term financial health of the company and may sacrifice the best long-term solution in favor for short-term benefits.

Even with the best practices in place, working capital management cannot guarantee success. The future is uncertain, and it's challenging to predict how market conditions will affect a company's working capital. Whether its changes in macroeconomic conditions, customer behavior, and supply chain disruptions, a company's forecast of working capital may simply not materialize as they expected.

Last, while effective working capital management can help a company avoid financial difficulties, it may not necessarily lead to increased profitability. Working capital management does not inherently increase profitability, make products more desirable, or increase a company's market position. Companies still need to focus on sales growth, cost control, and other measures to improve their bottom line. As that bottom line improves, working capital management can simply enhance the company's position.

?Working Capital Management

Working capital management aims at more efficient use of a company's resources by monitoring and optimizing the use of current assets and liabilities. The goal is to maintain sufficient cash flow to meet its short-term operating costs and short-term debt obligations and maximize profitability. Working capital management is key to the cash conversion cycle (CCC), or the amount of time a firm uses to convert working capital into usable cash.

Why ?the Current Ratio is Important

The current ratio (also known as the working capital ratio) indicates how well a firm is able to meet its short-term obligations, and it's a measure of liquidity. If a company has a current ratio of less than 1.00, this means that short-term debts and bills exceed current assets, a signal that the company's finances may be in danger in the short run.

Why Is the Collection Ratio Important?

The collection ratio, or days sales outstanding (DSO), is a measure of how efficiently a company can collect on its accounts receivable. If it takes a long time to collect, it can be a signal that there will not be enough cash on hand to meet near-term obligations. Working capital management tries to improve the collection speed of receivables.

Why the Inventory Ratio is Important

The inventory turnover ratio shows how efficiently a company sells its stock of inventory. A relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.

Working capital management is at the core of operating a business. Without sufficient capital on hand, a company is unable to pay its bill, process payroll, or invest in growth. Companies can better understanding their working capital structure by analyzing liquidity ratios and ensuring its short-term cash needs are always met.

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