Updated: Jan 13, 2020
Working Capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entities. Working capitals considered a part of operating capital. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
Working Capital = Current Assets – Current liabilities
Working capital is an important metric to evaluate a company’s health. This is because even profitable companies can turn bankrupt if they fail to manage their working capital properly. The working capital of a company should be positive. Companies with negative working capital are prone to financial risk and should be thoroughly evaluated.
Financial ratios like working capital turnover, current ratio and quick ratio prove very effective in judging the liquidity position of a company. So, a firm has to plan the effective utilization of its working capital in order to maintain equilibrium between liquidity and profitability of the business.
Working Capital Management requires monitoring a company's assets and liabilities to maintain sufficient cash flow.
The strategy involves tracking three ratios: the working capital ratio, the collection ratio, and the inventory ratio.
Keeping those three ratios at optimal levels ensures efficient working capital management.
Benefits of Working Capital Management
Working Capital management can improve a company's earnings and profitability through efficient use of its resources. Management of working capital includes inventory management as well as management of accounts receivables and accounts payable. The objectives of working capital management, in addition to ensuring that the company has enough cash to cover its expenses and debt, are minimizing the cost of money spent on working capital, and maximizing the return on asset investments.
Companies typically measure how efficiently that balance is maintained by monitoring the inventory turnover ratio. The inventory turnover ratio, calculated as revenues divided by inventory cost, reveals how rapidly a company's inventory is being sold and replenished. A relatively low ratio compared to industry peers indicates inventory levels are excessively high, while a relatively high ratio may indicate inadequate inventory levels.
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