Working Capital In Nutshell
The “short-term” period in the definition refers to the operating cycle i.e. the time required to convert the initial investment (outflows) in raw materials into sales (investments plus profits). For example, a manufacturer will need to buy raw materials (merchandise in case of a trader), spend money to convert them into finished goods and arrange for warehousing. If the funds required are raised from outside, they become current liabilities (mostly short-term borrowings). The next step is to sell the finished products to generate income. Cash and cash convertibles, such as inventories, finished goods and accounts receivable, form the current assets or gross working capital.
See Also: Estimating Working Capital Requirement
Net working capital is a more realistic parameter and used more commonly. It is the difference between your total current assets and total current liabilities. It indicates the actual amount of cash and cash convertibles available at a given point in time, after meeting outside obligations. A positive number means you are able to pay off your short-term obligations, while a negative working capital is not good news.
Working capital is also assessed as current ratio (current assets/current liabilities). If the ratio is less than 1, you have negative working capital and your business would be challenged to cover the short term or instant obligations. In case the working capital ratio is excessively high that could mean that the stock is too high or that you have extra money that you must be reinvesting into the business.
Though working capital is an important financial indicator for a business, it cannot provide you meaningful information in isolation. For example, a current ratio of less than 1 is almost always a red flag, but there is no ideal positive ratio that fits every situation. It depends upon industry, stage of the business, region and the state of the economy.
On the other hand, the analysis of each individual component of current assets/liabilities is equally important and this is where quick and super-quick ratios come in. Each element must be managed effectively. In case of receivables, for example, make sure your customers understand your payment conditions, as well as, that you follow up with them when they don’t pay on time. If you have customers, who continuously extend their payments out over sixty days, you might need to have them place a deposit on purchase in advance, or pay up the full amount up front or money on delivery, or pay in phases. If you do not manage your receivables well, it could have a negative impact on your money flow and working capital. At the same time, you must avoid excessively stringent conditions that may drive away your customers.
Eurion Constellation has been helping businesses in developing thorough understanding of these elements to create and readjust the cash, inventory and payables/receivables policies for maximum efficiency. Let us know your requirements at firstname.lastname@example.org