Working Capital Management: Definition, Calculation, and Importance

Working capital management is a business process that helps companies make effective use of their current assets and optimize cash flow. It’s oriented around ensuring short-term financial obligations and expenses can be met, while also contributing towards longer-term business objectives. The goal of working capital management is to maximize operational efficiency.

WHAT IS WORKING CAPITAL?

Working capital is calculated as current assets minus current liabilities. 

If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit and negative working capital.

A company can be equipped with assets and profitability but may fall short of liquidity if its assets cannot be readily converted into cash. Positive working capital is required to ensure that a firm is able to continue its operations and that it has sufficient funds to satisfy both maturing short-term debt and upcoming operational expenses. The management of working capital involves managing inventories, accounts receivable and payable, and cash.

CALCULATION

Working capital is the difference between current assets and current liabilities.

Formula: Working Capital∑Current Assets-∑ Current Liabilities

Current assets and current liabilities include four accounts which are of special importance. These accounts represent the areas of the business where managers have the most direct impact:

• cash and cash equivalents (current asset)
• accounts receivable (current asset)
• inventory (current asset), and
• accounts payable (current liability)

The current portion of debt (payable within 12 months) is critical because it represents a short-term claim to current assets and is often secured by long-term assets. Common types of short-term debt are bank loans and lines of credit.

An increase in net working capital indicates that the business has either increased current assets (that it has increased its receivables or other current assets) or has decreased current liabilities—for example, has paid off some short-term creditors—or a combination of both.

WORKING CAPITAL MANAGEMENT

Decisions relating to working capital and short-term financing are referred to as working capital management. These involve managing the relationship between a firm's short-term assets and its short-term liabilities. Working capital management ensures a company has sufficient cash flow in order to meet its short-term debt obligations and operating expenses.

Management will use a combination of policies and techniques for the management of working capital. The policies aim at managing the current assets (generally cash and cash equivalents, inventories and debtors) and the short-term financing, such that cash flows and returns are acceptable.

• Cash management. Identify the cash balance which allows for the business to meet day-to-day expenses but reduces cash holding costs.
• Inventory management. Identify the level of inventory which allows for uninterrupted production but reduces the investment in raw materials—and minimizes reordering costs—and hence increases cash flow. 

Besides this, the lead times in production should be lowered to reduce Work in Process (WIP) and similarly, the finished goods should be kept at as low a level as possible to avoid overproduction—see supply chain management; Just In Time (JIT); economic order quantity (EOQ).

• Debtors’ management. Identify the appropriate credit policy, i.e. credit terms which will attract customers, such that any impact on cash flows and the cash conversion cycle will be offset by increased revenue and hence Return on Capital (or vice versa); 
• Short-term financing. Identify the appropriate source of financing, given the cash conversion cycle: the inventory is ideally financed by credit granted by the supplier; however, it may be necessary to utilize a bank loan (or overdraft) or to "convert debtors to cash" through "factoring".

CONCLUSION

A positive working capital cycle balances incoming and outgoing payments to minimize net working capital and maximize free cash flow. 

Positive working capital implies there are sufficient current assets to meet current obligations. In contrast, companies are at risk of being unable to meet current obligations with current assets when working capital is negative.

Companies need to have enough cash available to cover both planned and unexpected costs, while also making the best use of the funds available to fuel growth. This is achieved by the effective management of accounts payable, accounts receivable, inventory, and cash.

Companies can use a wide range of solutions to support effective working capital management. These include:

• Electronic Invoicing
• Inventory Management
• Cash flow forecasting
• Supply chain finance
• Dynamic discounting
• Flexible funding