Effectively managing working capital in business is an essential financial management function by CFOs and the finance team. We provide a working capital management definition, working capital management examples, and working capital formulas. We explain what is management of working capital, including some ratios to manage working capital and spend management tips. We describe best practices for managing working capital and why working capital management is important.
What Is Working Capital Management?
Working capital management is managing the cash conversion cycle (CCC) from inventory purchases to the collection of accounts receivable to paying vendors’ accounts payable balances, employee payroll, other accrued liabilities, and short-term debt obligations on a timely basis with adequate financial resources for liquidity.
Working capital management analyzes and optimizes the relationship between current assets and current liabilities to operate a business effectively. The net working capital formula is current assets minus current liabilities. Current is short-term, meaning conversion to cash within twelve months or the length of a company’s operating cycle.
What Does Working Capital Management Entail?
Effective working capital management entails trend analysis by computing and tracking ratios and metrics, forecasting working capital balances by balance sheet category, assessing accounts receivable and accounts payable aging reports, inventory management, cash management, short-term accrued liabilities, and spend management.
Working capital management includes making a decision and taking action steps to improve each lever that influences working capital.
The U.S. Small Business Administration connects improving working capital flows to the cash cycle, calling it the “working capital cash cycle”:
“Most lenders are willing to provide working capital if they believe that you can manage the working capital cash cycle. The cash cycle refers to the continual flow of resources into and out of working capital accounts. These accounts are cash, accounts payable, accounts receivable, inventory, and accruals.”
Types of Working Capital
Types of working capital include:
- Net working capital—measured as current assets minus current liabilities, indicates liquidity to meet current financial obligations
- Gross working capital—highly liquid assets that can readily be converted to cash
- Fixed working capital—minimum cash and current assets to cover current liabilities (also called permanent working capital)
- Temporary working capital—the difference between net working capital and fixed working capital
- Special working capital—variable working capital for unique extra or unforeseen needs
- Seasonal working capital—additional working capital needed during peak business seasons
- Regular working capital—minimum working capital for normal operations, including payroll expenses, materials, and overhead
- Reserve margin working capital—additional working capital needed for unusual circumstances
How can your business improve working capital with better employee spend management?
Read about Tipalti Expenses to learn how your growing business can control all of its employee spend, including expense reimbursement.
Tracking Various Ratios
Corporate finance analyzes financial statements to compute ratios used in the management of working capital.
Working Capital Ratio (Current Ratio)
The working capital ratio formula is:
Working capital ratio (current ratio) = current assets âž— current liabilities
Why it’s Important
The higher the working capital ratio, also called the current ratio, the better the company’s liquidity to pay obligations once the short-term assets are converted to cash. A positive working capital ratio (greater than 1) is desirable.
How it Works
The working capital ratio expresses the components of working capital (current assets and current liabilities) as a ratio.
Quick Ratio
The quick ratio formula is:
Quick ratio = (current assets – inventory) âž— current liabilities
Why it’s Important
The quick ratio focuses on the current assets with faster conversion to cash. With the quick ratio, you understand the relationship between current assets readily converted to cash and current liabilities, leading to speedier liquidity.
How it Works
The quick ratio excludes inventory from the working capital ratio (current ratio).
Collection Ratio
The collection ratio computes the average number of days it’s taking to collect your company’s accounts receivable balance. Besides monitoring the collection ratio, use the accounts receivable aging report by each customer balance with open (uncollected) invoices.
Management of accounts receivable includes initially extending credit wisely to customers, expediting accounts receivable collections, and determining which customers are no longer credit-worthy or require COD (cash on demand) shipments or delayed shipments until collection is received.
Collection ratio = average accounts receivable âž— average daily net credit sales
Why it’s Important
The faster the business collects its accounts receivable by converting the current asset to cash, the greater the company’s ability to pay its suppliers and other short-term obligations. Compare the collection ratio with accounts receivable credit terms extended by your company to customers. When it takes longer to collect accounts receivable, as happens in economic slowdowns like recessions, your business will likely need short-term financing.
How it Works
The collection ratio is calculated by dividing the accounts receivable balance by average daily sales in one year using either 365 days or 360 days (which banks may use to calculate interest). Your business may compute the collection ratio more often, substituting the number of days in the accounting period.
For example, if the average accounts receivable balance is $4,600,000 for the year, the collection ratio may be computed as:
Collection ratio = $4,600,000 âž— $100,000 average daily net credit sales = 46 days
where,
Beginning of year accounts receivable balance $4,500,000 + end of year accounts receivable balance $4,700,000) âž— 2 = $4,600,000
Annual net credit sales = $36,000,000 âž— 360 = $100,000 average daily net credit sales
Collection ratio = $4,600,000 âž— $100,000 average daily net credit sales = 46 days (to collect accounts receivable)
Accounts Receivable Turnover Ratio
Compute the accounts receivable turnover ratio using the same information you used for the collection ratio.
Accounts receivable turnover ratio = annual net credit sales âž— average accounts receivable
How it Works
Using the data from the collection ratio calculation example, the accounts receivable turnover ratio is computed as follows:
Accounts receivable turnover = $36,000,000 average annual net credit sales
Average accounts receivable balance = $4,600,000
Accounts receivable turnover = $36,000,000 âž— $4,600,000 = 7.8 times per year
Why it’s Important
On average, accounts receivable turnover is the number of times your company collected accounts receivable in a year. Either track it as days to collect accounts receivable or the number of times receivables are collected in a year.
Inventory Turnover Ratio
The inventory turnover ratio computes the number of times that inventory is used in a business through the completion of sales. Note that the inventory balance may be written off for physical inventory or scrap losses, obsolescence, and valuation declines. Cost of goods sold includes raw materials, labor, and overhead costs (or finished goods), including inbound transportation costs for products sold.
Inventory turnover = cost of goods sold âž— average inventory
Why it’s Important
The faster a company sells its inventory, the less likely the business will have obsolete inventory to write off, and the more prosperous it will be.
The cash conversion cycle is quicker when financial management achieves excellent accounts receivable collection combined with fast inventory turnover.
To assess your company’s performance, benchmark inventory turnover (and other ratios) with comparable companies in your industry.
How it Works
Average inventory is computed as beginning inventory from the balance sheet for the period plus ending inventory at the end of the accounting period divided by 2. Cost of goods sold is from the income statement for the period analyzed.
For example, using one year as the time period:
where:
Beginning inventory = $4,000,000
Ending inventory = $4,600,000
Average inventory = ($4,000,000+$4,600,000) âž— 2 = $4,300,000
Cost of goods sold for the annual period = $17,800,000
Inventory turnover = $17,800,000 âž— $4,300,000 = 4.1 times for the year
Accounts Payable Turnover Ratio
The accounts payable turnover ratio calculates the number of times that accounts payable is paid to suppliers during the period analyzed compared to net credit purchases from suppliers or vendors. The accounts payable turnover ratio formula is:
Accounts payable turnover = Net credit purchases from suppliers for the period âž— average accounts payable balance
Why it’s Important
Accounts payable turnover is important to track because it lets you know your company’s efficiency in paying vendors when payments are due or taking early payment discounts. When the accounts payable turnover ratio is high, your company is meeting its vendor payments obligations.
How it Works
If net credit purchases from suppliers during the year total $20,000,000 and the accounts payable balance at the beginning of the year plus the end of the year divided by 2 (to compute average accounts receivable) is $2,500,000, then the accounts payable turnover ratio is 8 times.
Accounts payable turnover = $20,000,000 âž— $2,500,000 = 8 times
Days Payable Outstanding (DPO)
The days payable outstanding formula measures the number of days that accounts payable is unpaid, compared to net credit purchases from all suppliers during the period.
Transform the accounts payable turnover ratio to days payable outstanding by dividing the number of days in the period analyzed by the accounts payable turnover ratio. For one year, use either 360 or 365 days per year. You can analyze DPO more frequently, like monthly or quarterly, at the end of each accounting cycle.
Days payable outstanding = 360 days âž— accounts payable turnover ratio
Why it’s Important
Days payable outstanding is important because it allows you to track how many days of trade payables are outstanding and whether your company has enough cash to pay vendors in your supply chain on time reasonably within their payment terms.
Suppose corporate bills aren’t paid timely due to your company’s cash insufficiency to meet working capital needs. In that case, vendors you’ve selected for procurement may cut off shipments, which would negatively affect operational efficiency.
Your business may be able to slow down payments somewhat to balance payments timing with days sales outstanding from accounts receivable collections without triggering vendor ire. That will result in less short-term borrowing from bank lenders or other providers at higher interest rates. Check to see if a vendor charges late payment fees before delaying payment.
How it Works
If the accounts payable turnover ratio is 8, then days payable outstanding is computed as follows for the year:
Days payable outstanding = 360 âž— 8 = 45 days
What is the Difference Between Working Capital and Cash Flow?
Working capital and cash flow are different.
Working Capital vs. Cash Flow
Working capital compares current assets to current liabilities as a short-term measure of a company’s ability to pay bills and other short-term liabilities when due by analyzing the balance sheet. Cash flow measures the actual cash inflows and cash outflows of a business, as shown in the cash flow statement.
Importance of Working Capital Management
Working capital management is not just important. Effective management of working capital is an essential set of business processes. Besides contributing to profitability, financial management has a fiduciary duty to manage their company’s working capital effectively.
Working capital levers include invoicing and collecting accounts receivable quicker and paying AP bills reasonably on time while taking advantage of compelling early payment discounts from vendors. Inventory control, with good inventory levels, improves working capital by limiting the physical loss of inventory, obsolescence, rework, and scrap, enabling the business to convert inventory into cash as part of the cash conversion cycle.
Optimal working capital management and cash flow management contribute to the business’s financial health by having sufficient liquid assets when needed. Especially For a small business, the difference may be either becoming a thriving going concern or a business failure. But businesses of all sizes need good working capital management.
The financial team manages the forecasting and budgeting processes, including capital budgeting and discounted cash flow (DCF) analysis for significant long-term fixed asset investments and other capital investment projects.
The company’s financial management performs cash flow management and short-term assets and liabilities working capital management, matching the longer expected life of capital expenditures with long-term financing to protect liquid assets.
Adequate FP&A (financial planning & analysis) and budgetary controls ensure that operating expenses and capital expenditures spending is adequately controlled and financed, contributing to better working capital management and a shorter working capital cycle. Controlling global employee expenses with spend management and reimbursement is an essential part of working capital management. Download our white paper, “The Holy Grail of Accounts Payable.”
