Useful Financial Tools for Working Capital Management

Working capital is the lifeblood of any business. It determines the ability of the company to manage its cash flow to always have enough to meet its debt obligations. Managing the components of working capital is an essential skill of any business owner or manager. There are a number of different tools than can be used to manage working capital.

Working capital is defined as the total current assets, cash, receivables and inventory of a company, minus its current liabilities, which are all debts due in less than 12 months. It is a measure of the liquidity of a company. A manager's goal is to always be increasing working capital, which can be easily tracked on a daily or monthly basis. A business that is making a profit and has a positive cash flow should always be increasing its working capital position.

Every company should have a weekly cash flow schedule plotted on a spreadsheet that shows when money is coming in, going out and how much will be left. When a business sells its products on terms to a customer, the funds from the sale may not be collected for 30, 45 or even 60 days. Current liabilities, on the other hand, will typically have to be paid on shorter terms. This difference in timing illustrates the importance of having a large working capital position.

The turnover of accounts receivable is an important indicator of a company's ability to sell products and collect its funds. Accounts receivable turnover can be calculated as total sales divided by the amount of accounts receivable. For example, if a company had annual sales of $1.2 million and had average accounts receivable of $100,000 then its turnover ratio would be 12 times. If the company were selling on 30-day terms then this would be a perfect ratio. Unfortunately, the real world does not always work this way. If the accounts receivable balance were $150,000, then the turnover ratio would drop to eight, which indicates a collection period of 45 days, 360 days divided by eight.

Inventory turnover is another metric that affects working capital. This metric is calculated by dividing the total cost of goods sold by the inventory balance. A company needs to have an inventory balance that is sufficient to meet demand but not so much that it has stale inventory that is not selling.

Working capital turnover is calculated by dividing total sales by the amount of working capital. A ratio that is very high indicates that the working capital is working too hard and the company will have difficulty meeting its short-term debt obligations. A ratio that is very low is a sign that the company has excess working capital and the funds should be pulled out to invest in other assets that would be more productive. The optimum working capital turnover ratio for any business is a trial-and-error process to determine the best level of working capital.