Managing working capital effectively is critical to your company’s long-term success, and it is essential in assessing the organization’s overall financial health. Working capital is simply the difference between a company’s current assets and its current obligations, the ideal management of which provides a balance between growth, profitability, and liquidity.
Here are some common metrics and questions to ask yourself when assessing your company’s working capital needs.
Two commonly-used ratios relating to receivables are turnover and average days outstanding. When reviewing these ratios, ask yourself – how does your days outstanding compare to the terms you offer your customers? How does it compare to your competitors? If the metric is approaching or exceeding your normal credit terms, your collection procedures should be examined. Two easy ways to improve collection cycles are through the use of a lockbox account and by encouraging customers to use electronic fund transfers.
Inventory is another area that can be assessed through a turnover ratio, and by calculating the number of days of inventory on hand. Not enough inventory on hand could result in stock-out losses. Conversely, too much inventory on hand creates excess carrying costs.
Before analyzing inventory balances, you first need to determine your motive for holding inventory: transactional (just enough for normal production), precautionary (to avoid lost sales due to insufficient finished goods or replacement parts), or speculative (buying now to avoid future price increases or material shortages). Developing an Economic Order Quantity: Reorder Point (EOQ-ROP) model will help minimize order costs and carrying costs, and also help your business maintain a healthy inventory balance.
Liquidity is another important aspect of working capital as it indicates your company’s ability to meet its short-term obligations. Common metrics to assess liquidity are the current and quick ratios; however, calculating your cash conversion cycle can be a great way to determine what’s driving your company’s liquidity. The cash conversion cycle is the length of time it takes for a company’s investment in inventory to generate cash. It is calculated as the number of days of inventory on hand, plus receivables days outstanding, less payables days outstanding. The longer the cycle, the greater the company’s need for liquidity.
Lastly, there is cash management, and assessing the need for short-term financing. Effective monitoring of cash involves forecasting short-term cash flows, which can be done by looking at historical trends and operations: How quickly do your customers pay? How quickly do you pay your vendors? What are your average payroll costs? What are your short-term debt service requirements?
When forecasting cash flows, you should also look at your daily cash balances and determine whether you have too much cash. Can the excess be invested in short-term funds for a better return, or in capital expenditures?
Lastly, short-term financing options should be addressed to improve working capital management. When assessing financing options, consider the cost of borrowing and the benefit of that cost. Possible benefits include more manageable cash balances, the ability to maintain higher inventory levels and avoid stock-out losses, or the ability to offer longer terms to customers, which may lead to increased sales.
Working capital needs are unique for every company; however, the goal of effective capital management is the same: to develop a plan for the most productive use of your company’s resources.
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