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What Is Working Capital Management

Working capital management involves effectively managing current assets and liabilities to maintain sufficient cash flow and meet short-term obligations. It aims to free up trapped cash that can be used to fund business expansion, acquisitions, or R&D. While companies need cash available for planned and unexpected costs, too cautious an approach limits profitability. Effective working capital management optimizes capital usage and performance through tools like electronic invoicing, cash flow forecasting, supply chain finance, and dynamic discounting.

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Rohit Bajpai
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185 views

What Is Working Capital Management

Working capital management involves effectively managing current assets and liabilities to maintain sufficient cash flow and meet short-term obligations. It aims to free up trapped cash that can be used to fund business expansion, acquisitions, or R&D. While companies need cash available for planned and unexpected costs, too cautious an approach limits profitability. Effective working capital management optimizes capital usage and performance through tools like electronic invoicing, cash flow forecasting, supply chain finance, and dynamic discounting.

Uploaded by

Rohit Bajpai
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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What is working capital

management?
Working capital management – defined as current assets minus current liabilities – is
a business tool that helps companies effectively make use of current assets and
maintain sufficient cash flow to meet short-term goals and obligations. By effectively
managing working capital, companies can free up cash that would otherwise be
trapped on their balance sheets. As a result, they may be able to reduce the need for
external borrowing, expand their businesses, fund mergers or acquisitions, or invest
in R&D.

Working capital is essential to the health of every business, but managing it


effectively is something of a balancing act. Companies need to have enough cash
available to cover both planned and unexpected costs, while also making the best
use of the funds available. This is achieved by the effective management of accounts
payable, accounts receivable, inventory, and cash.

Working capital formula


Working capital is calculated by subtracting current liabilities from current assets.
That means that the working capital formula can be illustrated as:

Working capital = current assets – current liabilities

Current assets include assets such as cash and accounts receivable, and current
liabilities include accounts payable.

Other important working capital metrics include:

 Days Sales Outstanding (DSO) – the average number of days taken for the
company’s customers to pay their invoices.
 Days Payables Outstanding (DPO) – the average number of days that the company
takes to pay its suppliers.
 Days Inventory Outstanding (DIO) – the average number of days that the company
takes to sell its inventory.
 Cash Conversion Cycle (CCC) – the average time taken for the company to convert
its investment in inventory into cash.

CCC is calculated as follows:

CCC = DIO + DSO – DPO


The shorter a company’s CCC, the sooner it is converting cash into inventory and
then back to cash. Companies can reduce their cash conversion cycle in three ways:
by asking customers to pay faster (reducing DSO), extending payment terms to
suppliers (increasing DPO) or reducing the time that inventory is held (reducing
DIO).

Objectives of working capital management


Working capital is an essential metric for businesses to pay attention to, as it
represents the amount of capital they have on hand to make payments, cover
unexpected costs, and ensure business runs as usual. However, working capital
management isn’t that simple, and there can be multiple objectives of a working
capital management program, including:

 Meeting obligations. Working capital management should always ensure that the
business has enough liquidity to meet its short-term obligations, often by collecting
payment from customers sooner or by extending supplier payment terms.
Unexpected costs can also be considered obligations, so these need to be factored
into the approach to working capital management, too.
 Growing the business. With that said, it’s also important to use your short-term
assets effectively, whether that means supporting global expansion or investing in
R&D. If your company’s assets are tied up in inventory or accounts payable, the
business may not be as profitable as it could be. In other words, too cautious an
approach to working capital management is suboptimal.
 Optimizing capital performance. Another working capital management objective is to
optimize the efficiency of capital usage – whether by minimizing capital costs or
maximizing capital returns. The former can be achieved by reclaiming capital that is
currently tied up to reduce the need for borrowing, while the latter involves ensuring
the ROI of spare capital outweighs the average cost of financing it.

Effective working capital management


Speeding up the CCC can improve a company’s working capital position, but it may
also have other consequences. For example, there is a risk that reducing inventory
levels could negatively impact your ability to fulfil orders.

Where DPO is concerned, your accounts payable is also your suppliers’ accounts
receivable – so if you pay suppliers later, you may be improving your own working
capital at the expense of your suppliers’ working capital. This may have an adverse
effect on your relationships with suppliers and could even make it difficult for cash-
strapped suppliers to fulfil your orders on time.

Effective working capital management therefore means taking steps to improve the
company’s working capital position without triggering adverse consequences
elsewhere in your supply chain. This might include reducing DSO by putting in place
more efficient invoicing processes, so that customers receive your invoices sooner.
Or it might mean adopting an early payment program that enables your suppliers to
receive payment sooner than they would otherwise.

Working capital management solutions


Companies can use a wide range of solutions to support effective working capital
management, both for themselves and for their suppliers. These include:

 Electronic invoicing. Electronic invoice submission can help companies achieve


working capital benefits. By streamlining the invoicing process, you can reduce the
risk of errors, automate manual processes, and make sure that your customers
receive your invoices as early as possible – which may ultimately mean you get paid
sooner. Electronic invoice submission methods can enable companies to turn
purchase orders into invoices automatically or submit high volumes of invoices using
system-to-system integration.
 Cash flow forecasting. By forecasting future cash flows – such as payables and
receivables – companies can plan for any upcoming cash gaps and make better use
of any surpluses. The more accurately you can predict your future cash flows, the
better-informed your working capital management decisions will be.
 Supply chain finance. For buyers, supply chain finance – also known as reverse
factoring – is a way of offering suppliers early payment via one or more third-party
funders. Suppliers can improve their DSO by getting paid sooner at a low cost of
funding – while buyers can preserve their own working capital by paying in line with
agreed payment terms.
 Dynamic discounting. Dynamic discounting is another solution that buyers can use to
provide early payment to suppliers – but this time there’s no external funder, as the
program is funded by the buyer via early payment discounts. Like supply chain
finance, this enables suppliers to reduce their DSO. What’s more, it allows buyers to
achieve an attractive risk-free return on their excess cash.
 Flexible funding. Last but not least, working capital providers that offer flexible
funding may allow buyers to move seamlessly between supply chain finance and
dynamic discounting models, meaning companies can adapt to their varying working
capital needs while continuing to support their suppliers.

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