Working capital management is a measure of the operational liquidity of a business. It involves managing the relationship between a firm’s short-term assets and its short-term liabilities. The goal of effective working capital management is to ensure that a company has adequate ready access to the funds necessary for day-to-day operating expenses.
There are several factors that impact working capital needs:
Liquidity is the extent to which a company is able to meet its short-term obligations using assets that can be readily converted into cash (by selling or financing).
Liquidity management refers to the ability of an organization to generate cash when and where needed.
Two sources of liquidity for a company are:
A company’s liquidity position is affected by cash receipts and the amount of cash it has to pay.
Drags on liquidity reduce cash inflows. For example, bad debts, obsolete inventory, uncollected receivables, etc.
Pulls on liquidity accelerate cash outflows. For example, earlier payment of vendor dues, etc.
Liquidity contributes to a company’s credit-worthiness. Credit-worthiness is the perceived ability of the borrower to pay what is owed in a timely manner despite adverse conditions. A high credit-worthy company is one that has the ability to make interest payments on a loan as they come due.
High credit-worthiness allows a company to:
Liquidity ratios measure a company’s ability to meet short-term obligations. In the reading on financial ratios, we discussed all the ratios listed here.
In financial reporting and analysis, the turnover ratios were classified as activity ratios. But, here we consider them as a measure of liquidity as well because of the effect (drag/pull) they have on the liquidity of a company.
|Current ratio||Current assets ÷ Current liabilities|
|Quick ratio||(Cash + Marketable securities + Receivables) ÷ Current liabilities|
|Receivable turnover||Credit Sales ÷ Average receivables|
|Number of days of receivables||365 or days in period ÷ Receivable turnover|
|Inventory turnover||Cost of goods sold ÷ Average inventory|
|Number of days of inventory||365 or days in the period ÷ Inventory turnover|
|Payables turnover||Average day’s purchases ÷ Average trade payables|
|Number of days of payables||365 or days in the period ÷ Payables turnover|
Net Operating Cycle
Operating cycle is the time needed to convert raw materials into cash from a sale. It does not consider payments to suppliers.
Operating cycle = Number of days of inventory + Number of days of receivables
Net operating cycle is a more accurate measure which measures the time from paying suppliers for raw materials to collecting cash from customers. The shorter the cycle, the better is the cash-generating ability of a company.
Net operating cycle = Number of days of receivables + Number of days of inventory – Number of days of payables
The purpose of managing a firm’s daily cash position is to make sure there is sufficient cash (target balance). A company does not want low or negative balances because it is expensive to borrow cash on short notice. However, it does not want an unnecessarily high cash balance either because interest income is forgone by not investing the cash.
Companies should recognize the major sources of cash inflows and outflows in order to precisely forecast cash flows and maintain a minimum cash balance. Some common sources of cash inflows and outflows are listed below:
|Examples of Cash Inflows and Outflows|
|Receipts from operations||Payments to employees|
|Fund transfer from subsidiaries||Payments to suppliers|
|Maturing investments||Other expenses|
|Tax refunds||Debt payments|
|Money from loans||Taxes|