What Is Working Capital Management?

Working capital management is a business strategy designed

to ensure that a company operates efficiently by monitoring and using its current assets and liabilities
to their most effective use. The primary purpose of working capital management is to enable the
company to maintain sufficient cash flow to meet its short-term operating costs and short-term debt
obligations. A company's working capital is made up of its current assets minus its current liabilities.
Current assets include anything that can be easily converted into cash within 12 months. These are the
company's highly liquid assets. Some current assets include cash, accounts receivable, inventory, and
short-term investments. Current liabilities are any obligations due within the following 12 months.
These include accruals for operating expenses and current portions of long-term debt payments.
Why Manage Working Capital?
Working capital management helps maintain the smooth operation of the net operating cycle, also
known as the cash conversion cycle (CCC)—the minimum amount of time required to convert net
current assets and liabilities into cash. Working capital management can improve a company's cash flow
management and earnings quality through the efficient use of its resources. Management of working
capital includes inventory management as well as management of accounts receivable and accounts
payable. Working capital management also involves the timing of accounts payable (i.e., paying
suppliers). A company can conserve cash by choosing to stretch the payment of suppliers and to make
the most of available credit or may spend cash by purchasing using cash—these choices also affect
working capital management.
Key Components of Working Capital Management
1. Manage Liquidity: Proper liquidity management ensures that the organization has enough cash
resources to address its regular business needs. It is also significant because it affects a company’s
financial health, which can contribute to its success or failure.
If a greater amount of a company’s assets are tied up in illiquid assets, it might find it difficult to maintain
effective cash flows or pay its short-term debts.
2. Manage Account Receivable: Accounts receivables are balances that debtors have to pay to the
company. The amount becomes due when goods or services are delivered to a customer, but haven’t yet
been paid for. If a company finds it difficult to receive cash from its debtors, it may suffer from cash flow
problems. The collection ratio is often used to calculate the average time it takes for a company to
receive payment after a credit sale is made.
3. Manage Account Payable: Accounts payable refers to money due and owing by a company to its
vendors, shown as an obligation on a company’s balance sheet.
Managing accounts payable is very important for maintaining effective working capital. Late payments
could result in penalties or fines, and can damage a company’s credit ratings too. In some cases, non-
payment could lead to mandatory liquidation of assets to pay off creditors.
Managing accounts payable and making sure payments are made on time is a key component of working
capital management.
4. Managing Short-Term Debt: Managing short-term financing, like liquidity management, should
concentrate on ensuring that the organization has enough liquidity to monetize short-term operations
without taking huge risks. The efficient handling of short-term financing entails selecting the
appropriate financing mechanism and sizing the funds made accessible throughout.
5. Managing Inventory: Inventory is a company’s main asset used to generate sales revenue.
Investors view stock turnover as a clear indicator of a company’s sales capacity, as well as its purchasing
and manufacturing dependability. Low inventory levels indicate that the company is at an increased risk
of losing sales, whereas excessively high inventory levels may indicate inefficient use of working capital.
How to Improve Working Capital Management
Accelerating the cash conversion cycle can help a company’s working capital position, but it may have
unintended consequences. For instance, withholding payments to suppliers may improve your cash
position, but will affect your relationship with suppliers. This may hurt your relationships with
suppliers and could even make it difficult for cash-strapped suppliers to fulfill your orders on time. As
a result, efficient working capital management entails taking initiatives to strengthen the company’s
working capital position while preventing negative consequences elsewhere in your supply chain. It
often requires companies to strike a balance between liquidity and profitability.
Working Capital Management Objectives
Appropriate working capital management ensures that the firm always has enough cash to support its
short-term operational expenses and debt obligations. It also facilitates the smooth functioning of the
business and can help boost earnings and profitability. Moreover, working capital management
initiatives may have multiple objectives, such as:
1. Smooth Operating Cycle of Working Capital: The process of acquiring raw materials and converting
them into cash should be smooth and straightforward. To effectively manage the operating cycle,
consider these limitations:
1) The raw material should be ordered from reliable vendors.
2) All production requirements should be in place ahead of schedule.
3) Finished goods should be sold as soon as they are manufactured and stocked.
4) Accounts receivable should be collected on time.
5) Accounts payable should be paid as soon as they become due.
6) When cash is needed, it should be readily available.
2. Maintaining Optimum Working Capital: Companies need to maintain a balance for effective
working capital management. Higher working capital broadly translates to greater efficiencies, and is
used as an indicator for growth.
3. Meeting Debt Obligations: Working capital management should always make sure that the company
has more than enough liquidity to meet its short-term commitments, which can be accomplished by
collecting payments from customers quicker or by prolonging supplier payment terms.
4. Fueling Business Growth: If your company’s assets are encumbered by poor inventory control or
accounts payable practices; it’s often difficult to grow. Effective working capital management focuses on
minimizing the cost of spent capital, while maximizing returns on current investments.
This ultimately fuels business growth and allows companies to function more efficiently in the long run.
5. Improving Capital Performance: Another goal of working capital management is to enhance the
utilization of capital usage, whether by lowering capital costs or increasing capital returns.
The former can be accomplished by unlocking cash on the balance sheet to reduce the need for debt.
Working capital management represents the relationship between a firm’s short-term assets and
its short-term liabilities. It aims to ensure that a company can afford its day-to-day operating expenses
while also investing the company’s assets in the most successful direction possible. Working capital
management is possible by opting for modern solutions to create efficiency in the procurement and AP
departments. This helps unlock cash that’s tied up on the balance sheet. SoftCo Procure-to-Pay is a
comprehensive solution for automating the entire finance process, from procurement until payment. It
gives finance leaders a detailed oversight regarding procurement operations, allowing them to identify
key opportunities for cost savings.
What Is Working Capital?
Working capital, also known as net working capital (NWC), is the difference between a
company’s current assets—such as cash, accounts receivable/customers’ unpaid bills, and inventories
of raw materials and finished goods—and its current liabilities, such as accounts payable and debts. It's
a commonly used measurement to gauge the short-term health of an organization.
Understanding Working Capital: Working capital estimates are derived from the array of assets and
liabilities on a corporate balance sheet. By only looking at immediate debts and offsetting them with the
most liquid of assets, a company can better understand what sort of liquidity it has in the near future.
Working capital is also a measure of a company’s operational efficiency and short-term financial health.
If a company has substantial positive NWC, then it could have the potential to invest in expansion and
grow the company. If a company’s current assets do not exceed its current liabilities, then it may have
trouble growing or paying back creditors. It might even go bankrupt.
Working Capital Formula: To calculate working capital, subtract a company's current liabilities from
its current assets. Both figures can found in the publicly disclosed financial statements for public
companies, though this information may not be readily available for private companies.
Working Capital = Current Assets - Current Liabilities
Working capital is often stated as a dollar figure. For example, say a company has $100,000 of current
assets and $30,000 of current liabilities. The company is therefore said to have $70,000 of working
capital. This means the company has $70,000 at its disposal in the short term if it needs to raise money
for a specific reason.
When a working capital calculation is positive, this means the company's current assets are greater than
its current liabilities. The company has more than enough resources to cover its short-term debt, and
there is residual cash should all current assets be liquidated to pay this debt. When a working capital
calculation is negative, this means the company's current assets are not enough to pay for all of its
current liabilities. The company has more short-term debt than it has short-term resources. Negative
working capital is an indicator of poor short-term health, low liquidity, and potential problems paying
its debt obligations as they become due.
Let us discuss some of the major Difference between Profitability vs Liquidity:
Profitability refers to the company’s improvement in margins; margins refer to revenue – cost the more
the margins are increasing; it reflects enhanced profitability in the company for that financial year.
Profitability enhances the equity reserves and growth prospects of the company. On the other hand,
liquidity refers to the ability of the firm to meet short-term and long-term obligations which the
business needs to pay in the long run and the short-run the current portion of liabilities
One of the key differences is that it is not necessary always that the profitable company is also liquid in
nature that is because the company has invested heavily In the future projects of the company from
which the receivables are due after a considerable period of time. This is a major difference that needs
to be understood when making financial projections for any company. A company that is not liquid in
nature can also go bankrupt in the short run because it does not have enough liquidity in its hands that
is why the company needs working capital to meet short-term obligations
Profitability is a measure of business success; that is how well the company is performing over a period
of time; it is not an indication of how cash-rich the company is. It cannot tell the analyst the cash position
of the company. Liquidity, on the other hand, tells us the cash position of the company, too much cash
on the balance sheet also indicates poor working capital management of the company as the company
is bearing the opportunity cost of cash which is lying idle on the balance sheet
Profitability is the financial performance measure of the company, which is indicated in the income
statement and is reported as Net profit in the profit and loss account. If the net profit is negative, it
indicates that the company is bearing losses in that period. Liquidity is present in the balance sheet on
the current assets section of any balance sheet of the company which includes marketable securities,
prepaid expenses, and inventories apart from cash
Profitability vs Liquidity Comparison Table
Below is the 6 topmost comparison between Profitability vs Liquidity
Profitability Liquidity

Profitability is for a period and it not a position for Liquidity is for a particular time, and it is as on
a particular time date position and not for a particular time period

Profitability is an income statement item and not a Profitability is a balance sheet item and not an
balance sheet item income statement item

The Key ratios to determine the profitability of the The Key ratios to determine the Liquidity of the
company is:- company is:-
Gross Profit Margin Current Ratio
Net Profit Margin Acid Test Ratio
EBIDTA Margin Quick Ratio
EBIT Margin Interest Coverage Ratio
CAGR Fixed Coverage Ratio

Profitability is more important in the long run of Liquidity is more important in the short run of
the business the business
 Profitability is a measure of financial performance Liquidity is a measure of a cash position in the
company and how the liquid is the company is to
meet its short-term obligations

Profitability is also a degree of how well the Liquidity is the degree to how well the company
company is generating margins from its business can convert its sales into cash
Conclusion
Both Profitabilities vs Liquidity is important for a business as it is a vital aspect for a company. If the
company does not have enough cash on its hands, the working capital management will go for a toss,
and the company needs to look for a working capital loan which in turn will increase the interest cost
of any business. Profitability is also a vital aspect as the company needs to analyze the reason for low-
profit growth and also focus on cost reduction.
Factors Determining the Requirements of Working Capital
In case of a small-scale enterprise, the important factors determining the requirements of working
capital are as follows:
1. Sales: Among the various factors, size of the sales is one of the important factors in determining the
amount of working capital. In order to increase sales volume, the enterprise needs to maintain its
current assets. In the course of period, the enterprise becomes in the position to keep a steady ratio of
its current assets to annual sales. As a result, the turnover ratio, i.e., current assets to turnover increases
reducing the length of operating cycle. Thus, less the operating cycle period, less will be requirements
for working capital and vice versa.
2. Length of Operating Cycle: Conversion of cash through various stages viz., raw material, semi-
processed goods, finished goods, sales, debtors and bills receivables into cash takes a certain period of
time that is known as ‘length of operating cycle’. Longer the operating cycle time, the more is the working
capital required.
For example, heavy engineering needs relatively more working capital than a rice mill or cotton spinning
mill or a steel rolling mill. Thus, it follows that depending upon the length of working cycle, the
requirement for working capital varies from enterprise to enterprise.
3. Nature of Business: The requirement of working capital also varies among the enterprises
depending upon the nature of the business. For instance, trading companies require more working
capital than manufacturing companies. This is because that the trading business requires large
quantities of goods to be held in stock and also carry large amounts of working capital than
manufacturing concerns.
In both these types of businesses, the value of current assets is 80% to 90% of the value of total assets.
The investment in current assets is relatively smaller in the case of hotels and restaurants because they
mostly have cash sales, and only small amounts of debtors’ balances.
4. Terms of Credit: Another important factor that determines the amount of working capital
requirements relates to the terms of credit allowed to the customers. For instance, an enterprise may
allow only 15 days credit, while another may allow 90 days credit to its customers. Besides, an
enterprise may extend credit facilities to its all customers, while another enterprise in the same business
may extend credit only to select and those too reliable customers only.
Then, the requirements for working capital will naturally be more if the credit period is longer and credit
facilities are extended to all customers, no matter reliable or non-reliable they are. This is because there
will be longer balance of debtors and that too for a relatively longer period which will obviously demand
for more capital. On the contrary, if supplies of raw materials are available on favorable conditions or
terms of credit i.e., the payment will be made after a relatively longer period of time, the requirement
for working capital will be correspondingly smaller.
5. Seasonal Variations: The seasonal enterprises, i.e., the enterprise whose operations pick up
seasonally may require more working capital to meet their increased operations during the particular
season. A popular example of seasonal enterprise may be sugar factory whose operations are highly
seasonal.
6. Turnover of Inventories: If inventories are large in size but turnover is slow, the small-scale
enterprise will need more working capital. On the contrary, if inventories are small but their turnover
is quick, the enterprise will need a small amount of working capital.
7. Nature of Production Technology: In case of labour intensive technology, the unit will need more
amount to pay the wages and, therefore, will require more working capital. On the other hand, if the
production technology is capital- intensive, the enterprise will have to make less payment for expenses
like wages. As a result, enterprise will require less working capital.
8. Contingencies: If the demand for and price of the products of small- scale enterprises are subject to
wide variations or fluctuations, the contingency provisions will have to be made for meeting the
fluctuations. This will obviously increase the requirements for working capital of the small enterprises.
While one can add certain other factors to this list, the said factors appear to be the major ones in
determining the requirement of working capital of a small-scale enterprise.
Effective working capital management is a mark of a good business, but growing businesses and high
sales will strain cash flow and offset the balance of working capital. It’s a paradoxical challenge that a
growing business causes increased expenses and a lack of working capital while cash is needed the
most. The following working capital management best practices will help your business to better run
operations, pay employees, and secure financing.
Reduce inventory and increase inventory turnover: Well-managed inventory management may
be the most powerful leverage to working capital improvements. Achieving a higher net working capital
calculation can be achieved by reducing slow-moving inventory, increasing the inventory turnover
cycles, and avoiding stockpiling. Although inventory is considered an asset in the working capital
formula, less inventory on the shelves equates to more free up cash flow. Enabling cash efficient
production and operation techniques can be achieved by pull inventory methods such as the just-in-
time strategic method of inventory management. Applying these methods as well as utilizing inventory
automation systems or e-procurement can greatly reduce costs and boost capital through hyper-
efficient inventory management systems.
Utilizing the inventory turnover ratio or days inventory outstanding (DIO) metrics that reveal the
average number of days a company holds its inventory before selling it will allow a company to better
understand its inventory turnover. An analytical working capital management team will periodically
measure turnover rates, compare it to industry competitors, and uncover opportunities to reduce their
DIO that result in increased savings and working capital. Efficient inventory management can have a
significant impact on accounts receivables, accounts payables, operations, and overall profitability and
growth.
Pay vendors on time and manage debtors effectively: Enforcing payment discipline should be a
key part of your payables process. Analysis of working capital levels shows that the biggest
improvement comes from improved payables performance and reduced days payable outstanding
(DPO). The best way to ensure you have enough working capital available is to make sure money is
coming in on time. Reassessing your contracts and credit terms with debtors may be necessary to make
sure you are not giving debtors too big a window to pay for goods and services, as this may be impacting
negatively on your own company’s cash flow. CFOs should review credit terms with company
management to ensure that the level of credit being offered to debtors is appropriate for your company’s
cash flow needs. To reduce bad debts, you should implement more rigorous credit checks and ensure
that effective credit control procedures are in place for chasing late-paying customers.
Convert to electronic payables and receivables: In order to shorten the receivables period,
organizations need to have a good collections system in place. One important aspect of working capital
is to send out invoices as soon as possible. Companies should reassess invoicing processes in order to
eliminate inefficiencies that may be causing delays in sending invoices to your debtors. Such
inefficiencies may include manual processing, lost invoices, and high volume of invoices to manage. The
conversion from paper to electronic transactions has transformed payment processes. Electronic
payments are a well-known trend, but optimizing payables and receivables with automated processes
is imperative to cash efficiency and accelerated cash conversion cycles. Electronic payables processes
such as purchasing cards can offer working capital increases in a company’s accounts payables.
Automated payments and electronic payment processes can open the door to favorable capital
conserving payment terms, savings on rebate structures, and significant cost reductions. Utilizing
accounts receivables technology to deliver invoices electronically can also potentially shorten the
receivables period and the CCC. Electronic receivables will reduce manual processing, error, lost
invoices, and will ensure proper management with reminders eliminating some timely inefficiencies.
Receive adequate financing: Receiving working capital financing to increase working capabilities is
achieved by possessing enough liquidity to finance current operations without taking on excessive risk.
By analyzing working capital KPI’s and determining working capital needs can direct a business to
carefully selecting the right financing solution and adequate fund size for forecasted operational needs.
In addition to short-term business loans, a business may instead opt for financing fixed assets with a
long-term loan to stabilize healthy cash flow. Using existing cash flow to pay suppliers or fulfill purchase
orders can potentially earn strong relationships, secure discounts, and increase cash return on asset
investments counteracting the paid interest.