The Fundamentals of Working Capital Management (2024)

For most businesses, optimizing cash flow is a balancing act between maintaining short-term obligations and making wise use of available cash.

Spend too much, and you may have trouble paying vendors, making payroll, keeping up fixed asset costs, or paying for outside services. Spend too little, and you risk stifling growth and creating friction in your production process.

Striking a balance requires a constant, steady eye on your assets and liabilities. Working capital management is a well-managed, high-visibility approach to keeping the purse.

Today we’ll introduce the basics of effective working capital management:

• What working capital management is and how it’s done
• Why managing capital is vital to the financial health of your business
• Financial formulas for assessing working capital management
• How financial tools improve working capital management

Read on to learn more about creating a robust financial basis for your business.

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What is working capital management?

Managing a company's cash flow is all about balancing the company’s current assets and liabilities.

• Current assets are any funds or tangible assets that can be converted into cash within one year. Examples of current assets include cash, accounts receivable payments from customers, inventory on hand, and short-term investments.

• Current liabilities are any obligations due for payment within one year. These include operating expense accruals, installments of long-term liabilities, etc.

Working capital management is the strategic deployment of cash to achieve this balance and maintain healthy asset/liability ratios. Using working capital management, businesses can ensure they have enough cash on hand to meet their obligations and ensure steady growth for the organization.

This management of working capital is part of the cash conversion cycle (also known as the CCC or the net operating cycle). The cash conversion cycle refers to the minimum time required to change net current assets and liabilities into cash.

Why manage working capital?

Working capital management is the cornerstone of the sound financial administration of your business. If you don’t keep an eye on the cash in your bank account and mind the efficiency of its use, you will be unable to react to change or mitigate issues.

Implementing strong capital management offers the following benefits:

• Better liquidity: Liquidity is essential for responding to changing market conditions and business needs. By improving your access to liquid assets, you insulate your organization against adverse financial outcomes.

• More manageable growth: Well-managed cash is better able to fuel growth in your organization. Responsible cash management empowers your finance team to put capital toward revenue generation projects that move the needle.

• Increased profitability: When you make efficient use of cash to buy inventory, pay vendors, and repay loans, you reduce the amount spent on working capital. The money you save by increasing efficiency effectively increases the profit margin you make selling products and services.

• Lower receivables time: Establishing a well-executed cash management program also improves communication with vendors. This closer working relationship can speed up receivables payment and reduce payment issues.

• Higher cost efficiency: Strategically deploying capital dramatically improves the overall financial performance of your procurement and accounting functions. By spending strategically and bringing down total costs, your spend management becomes more efficient.

• Stronger vendor relationships: Paying vendor invoices in a timely manner can lead to early payment discounts. It also strengthens your relationships with those vendors. With strong partnerships, you may be able to negotiate better payment terms and greater supply chain resilience.

• Effective inventory management: Capital management relies heavily upon visibility into your cost centers. Improving data around inventory levels and turnover allows you to manage those cost centers and resources better.

Working capital management ratios

Finance teams use several formulas and metrics to understand and regulate the balance of working capital on the balance sheet. The three following formulas provide a snapshot of working capital efficiency:

1. Current ratio (working capital ratio)

The current ratio metric provides a high-level picture of your overall capital performance and ability to repay debts. This formula reveals the total amount of current short-term liabilities on the balance sheet and how they impact your current asset level. The formula is as follows:

Working capital ratio = current assets / current liabilities

• A result below 1.0 indicates that the company may be unable to meet short-term debt obligations.
• A result above 2.0 might suggest ineffective use of available assets or the need for better working capital management.

Most companies aim for a happy medium result, somewhere from 1.2 (basically, the ability to meet obligations with a comfortable buffer) to 2.0. This indicates effective use of cash without being overly conservative.

2. Collection ratio (days sales outstanding)

Managing cash also means being paid on time for the products and services you sell to customers. The collection ratio (also known as days sales outstanding, or DSO) measures the average number of days it takes to pay receivables. This reveals how well your organization is managing repayments. DSO is essentially the other side of the coin from days payable outstanding (DPO).

Here is the formula:

Collection ratio = average amount (in dollars) of outstanding accounts receivable / total net credit sales during the period x days in accounting period

If your DSO is too high, it suggests a needed change in invoicing and receiving payment for items or services sold on credit to customers.

3. Inventory turnover ratio

Having enough inventory on hand to meet your obligations is important to smooth your operations and brand reputation. Too much inventory, however, points to inefficient use of resources—you have too much paid-for inventory sitting in the warehouse waiting to be sold.

The inventory turnover ratio compares company inventory levels and usage to industry benchmarks to shed light on the balance of inventory levels versus demand.

Inventory turnover ratio = cost of goods sold (COGS) / average balance sheet inventory

The goal of the inventory turnover ratio is to balance incoming and sold inventory. If the ratio is too low, this metric may point to difficulty keeping inventory in stock. A ratio on the high side suggests either insufficient sales to turn over inventory or overbuying.

Managing your working capital on a spreadsheet is both time-consuming and inefficient. Manual data entry and calculation of assets and liabilities are prone to errors that can create an incorrect picture of your current net working capital.

Fortunately, software tools automate the process and create real-time visibility into your organization's financial picture.

Software that centralizes and automates the procure-to-pay process provides many helpful functions and advantages:

• Understanding how new purchases and short-term debt affect your overall financial position
• Viewing aging on both accounts payable and accounts receivable
• Automating vendor and customer invoicing and payments
• Viewing important capital metrics to make decisions about short-term spending and debt leveraging
• Viewing current inventory levels and inventory aging to ensure sufficient quantity and turnover
• Creating effective forecasting of working capital and future spending initiatives
• Increasing the operational efficiency of your purchasing process

The right procurement software can greatly increase the effectiveness of your working capital management. By centralizing the purchasing data your business uses to evaluate cash flow, you will gain a clearer picture of your total spending for indirect procurement. Automated invoicing and payment processes mean you can take advantage of early payments. And integrating the information from your procurement process with other finance systems can create line-level clarity on your organization’s spending practices.

Order.co’s procurement solutions help improve the working capital management of some of the world’s fastest-growing companies. To see how it can work for your organization, schedule a demo.