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Working Capital Management Explained

What Is Working Capital Management?
Lauren Ward
Lauren WardUpdated July 6, 2023
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What is working capital management? Working capital management occurs whenever a company makes internal changes to ensure its working capital is as strong as possible. The goal isn’t simply to make sure it has enough money to pay its debts and expenses, it’s also to maximize profitability and cut wasteful spending. Because market conditions can change every day, working capital management is necessary to ensure a business’s longevity.   

What Is Working Capital Management?

Before we define working capital management, let’s first explain working capital. Working capital definition: Working capital is the difference between a company’s assets and its liabilities. The formula for working capital is:Current Assets — Current Liabilities = Working CapitalWorking capital is the amount of money a company has to meet its current obligations and needs. How much does it have to cover its operating expenses? Does it have enough to cover its short-term debts? After it has done so, is anything left over? All day-to-day operations and expenses should be covered by working capital, as should investment money. While there are a variety of business loans, companies must first be able to handle the additional monthly payment, which comes from working capital. Working capital management, on the other hand, is the process of identifying and managing all of a company’s short-term assets (as well as its short-term debt and accounts payable) to ensure it has enough working capital to pay for things like inventory, utilities, rent, and payroll. If any changes are needed, they are found via working capital management.The ultimate purpose of working capital management is efficiency. What strategy can be adopted to increase working capital? What expenses can be cut or lowered? How can accounts receivable and payable be improved upon? All of these questions stem from working capital management.   Recommended: Applying for a Business Loan

How Working Capital Management Works

Working capital management is essentially a daily practice, and requires consistent observation and analysis. The purpose of working capital is to ensure a company has enough cash flow to pay for two things: 1) operating expenses, and 2) short term debts. To ensure it can pay for these things, inventory, cash, accounts payable and accounts receivable must be monitored and adjusted as needed.   

Why Is Managing Working Capital Important?

Working capital is what keeps a business’s doors open. Therefore, the management of working capital is of the utmost importance. When a company’s cash flow is reduced because of accounts receivable, accounts payable, or inventory, something needs to be addressed. There are many working capital management examples of companies that did not make the necessary changes when they were needed. Unfortunately, when business operations become unreliable and erratic, customers may start thinking about taking their business elsewhere. 

What Factors Affect Working Capital Management?

While working capital is influenced by many things, there are essentially two categories that affect a company’s working capital: endogenous factors and exogenous factors — or, in other words, internal variables and external variables. Endogenous factors include things like:
  • Inventory
  • Accounts payable
  • Debt
    • Short term and long term
  • Size and structure of company
  • Business strategies that affect sales and operations
Exogenous factors includes:
  • Interest rates
  • Economic conditions
  • Fellow competitors
  • Global events
  • Supply chain issues
Many things in the exogenous realm cannot be avoided, but they can be mitigated. While working capital management is primarily an analysis of endogenous factors, exogenous factors can be of equal importance. No business owner can change global events, but they can adapt and pivot their strategies accordingly — such as reduce their number of employees, seek out an investor, or apply for an emergency small business loan. Working capital management requires an analysis of all variables that can affect a business.

Current Ratio

To calculate the current ratio, divide a company’s current assets by its current liabilities. If the result is 1.0 or below, this is an indicator that working capital issues are on the horizon because there is more short-term debt than there are current assets. Unless changes are made, the company may need to sell a long-term asset, meet with investors, or look into working capital loans for small businesses to shore up its cash flow needs. If the ratio is two or higher, it’s possible that the company is not utilizing its assets to the best of its abilities. Could the cash be invested? Is it time to explore business loans and think about expanding? Current ratio is pivotal for the effective management of working capital, stability, and growth. Recommended: Working Capital Line of Credit

Collection Ratio

A company’s collection ratio refers to its ability to follow through on its accounts receivable. When customers receive a product or service without paying for it in a timely manner, this can create a working capital issue. Therefore, the goal of calculating collection ratio is to estimate how many times a company is able to collect upon its debts / accounts receivable within a given timeframe. It is not to be confused with days sales outstanding or average collection period, which estimate the amount of time it takes to collect money from credit sales. Instead, collection ratio is about the number of times a company is able to collect.To determine a company’s collection ratio, the first step is to calculate the average accounts receivable. For this, determine the length of time you want to analyze. If doing a year, add up the accounts receivable at the beginning of the year and the end. Then divide the sum by two to get the average. Next, calculate net credit sales. This is the amount of sales customers made on credit, which ultimately funnel into accounts receivable. The formula to calculate net credit sales is:Sales Made on Credit — Sales Returns — Sales Allowances (price reductions) = Net Credit SalesLastly, divide net credit sales by average accounts receivable to determine a company’s collection ratio. The higher the number, the better. 

Inventory Turnover Ratio

One of the primary jobs of a business owner who works with inventory is to ensure that their business has enough inventory to satisfy its customers. It’s a careful balance of minimizing costs through things like wholesale discounts and shipping, while not stockpiling unnecessary amounts and paying for storage. Unsurprisingly, inventory turnover can make or break many types of companies. The formula to calculate inventory turnover ratio is:Cost of Goods Sold/ Average inventory = Inventory Turnover RatioTo determine the average amount of inventory you have, first establish what period of time you want to analyze. If doing a yearly analysis, add up the total cost of the inventory you have at the beginning of the year and the end of the year, then divide by two.Dividing COGS by average inventory will give you an approximation of how many times you were able to turnover inventory. A low ratio suggests that inventory levels are too high and that there may be a lack of interest in a particular product. Perhaps it’s a seasonal item, or it may have gone out of fashion. On the other hand, a high ratio suggests there is too little inventory to meet your customers’ needs and shopping habits. You may choose to analyze your entire inventory, or you can look at certain groups or one specific item. Odds are that you already have a good idea of what’s moving and what’s not, but it’s a good exercise to do because you may notice something that will cause you to rethink your game plan. Also, play around with different times of year or lengths of time. Maybe you’ll notice a consistent increase or decrease that will cause you to move an item’s location on your store or website.

Key Aspects of Working Capital Management

 Effective working capital management boils down to the following factors:
  • Inventory
  • Accounts payable
  • Accounts receivable
  • Short-term debt
  • Cash 
As discussed, any issue in one category can affect the others. Business owners must ultimately be like helmsmen — they must continually make adjustments to their ships to stay on target.

Small Business Tips 

Effective working capital management involves a careful analysis of three ratios: current ratio, collection ratio, and inventory turnover ratio. It also involves a complete awareness of short-term debt, accounts payable, accounts receivable, inventory, and cash. Strong business owners know how to use their working capital to the best of their ability, and they do so through continuous working capital management.

The Takeaway

Implementing a working capital management strategy makes sure you're maximizing profitability and setting up your small business to succeed in the long run. You'll also know when you need financing before it's too late — whether you have a shortfall in cash flow or an expansion opportunity.Discover different options for business loans with Lantern Credit.

Frequently Asked Questions

What are the types of working capital management?
What are the components of working capital management?
Why is working capital management important?
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About the Author

Lauren Ward

Lauren Ward

Lauren Ward is a personal finance expert with nearly a decade of experience writing online content. Her work has appeared on websites such as MSN, Time, and Bankrate. Lauren writes on a variety of personal finance topics for SoFi, including credit and banking.
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