Working capital refers to the cash, a business requires for day-to-day operations, or, more specifically, for financing the conversion of raw materials into finished goods, which the company sells for payment. In simple words it is available capital for a business to meet its day to day cash requirements for its operations.
To explain with an example:
Suppose a company invests 100 $ to build up its inventory of raw materials to manufacture a product. After 10 days, company utilizes all raw materials in manufacturing the product and ships the same to customer. After 10 days, company receives the payment for the shipment. Now working capital is 100 $ which was tied up for 20 days.
The quicker the company sells the product, the sooner the company can go out and buy more raw materials and hence increase the productivity. If the raw materials are not utilized for longer period of time, company’s cash is tied-up and cannot be used for increasing the productivity and even worse, without cash, bills cannot be paid resulting in increase of debts and less cash for future investments. Working Capital also gets trapped when customers do not pay their invoices on time or suppliers get paid too quickly or not fast enough.
Calculating Working Capital is very important to understand your financial obligations and available current assets to fulfill them. It is calculated as:
Working capital = Current Assets – Current Liabilities
Current Assets includes cash liquidity or other assets such as accounts receivable, prepaid expenses, inventories & securities, which can be converted to cash within 1 year
Current Liabilities includes the liabilities which need to be paid within 1 year such as accounts payables, salaries, taxes and others.
Working Capital Ratio is calculated as ratio of Current Assets and Current Liabilities. It indicates whether a company has enough short term assets to cover its short term debt. If the ratio is anything below 1, it indicates negative working capital which means you are unable to meet your current liabilities and too higher ratio means too much inventory or less investment of excess cash in other words poor use of capital.
The goal of managing working capital is to ensure that a firm is able to continue its operations and that it has sufficient ability to satisfy both maturing short-term debt and upcoming operational expenses. Among the most important items of working capital are levels of inventory, accounts receivable and accounts payable.
Efficient working capital management includes planning and controlling of current liabilities and assets in a way it avoids excessive investments in current assets and prevents from working with few currents assets insufficient to fulfill the responsibilities. The 2 most important things are the analysis of Working Capital Ratio and managing the components of your working capital. In relevant studies the measure taken as an indicator of efficiency in working capital management is usually cash conversion cycle. Cash conversion cycle for a firm is the period during which it is transited from money to good and again to money.
Cash Conversion Cycle
Cash Conversion Cycle is the time in days taken by a company to convert resource inputs into cash.
It is used to measure the number of days cash is tied up in manufacturing and sales operations before it gets converted into payments through sales. It is calculated based amount of time needed to sell inventory, the amount of time needed to collect receivables and the length of time the company is afforded to pay its bills without incurring penalties.
CCC = DSO + DIH – DPO
DSO = Days Sales Outstanding
DIH = Days Inventory Held
DPO = Days Payable Outstanding
CCC helps by looking at how quickly the company turns its inventory into sales, and its sales into cash, which is then used to pay its suppliers for goods and services.
Shorter CCC means greater liquidity, which enables company to clear all debts and more opportunities for investing in expansion of business in new product lines and markets. Conversely, a longer CCC increases a company’s cash needs and negates all the positive liquidity qualities just mentioned.
Let see the role of individual factors which affects cash conversion cycle
Days Sales Outstanding
Days Sales Outstanding, in simple term, means the average time taken to receive the cash after the sale is made (i.e. how long sales remains in Accounts Receivable).A DSO of 20 means, it takes 20 days for a company to realize money from the customer for the sale made. Low DSO means fewer days to collect accounts receivable. High DSO values over a period of time indicates that customers are taking longer time to pay their bills and detailed analysis of same can highlight potential issues in paying behavior of customers like Product or Service strategy, Credit worthy, Payment terms and others.
It’s an important tool for measuring liquidity for the company. It’s in best interest of company to employ all the best practices possible to quickly turn sales into cash which can be used for re-investing and making more sales.
Days Inventory Held
DIH is an important measure of CCC which indicates the average number of days which company holds the inventory (including goods that are work in progress, if applicable) before turning it into sales. A DIH of 20 means, it takes 20 days for a company to convert inventory into sales. This measure depends on the nature of industry for e.g. companies manufacturing large machineries can have higher DIH as compared to small goods industries. Reducing number of DIH over a period of time indicates that a company is managing its inventory well and turnaround time from inventory to sales is very good. If DIH increases in particular period of time, necessarily it is not a bad thing as companies normally do it before the launch when they foresee in increases of demand.
Measuring DIH over a period of time is very important and the companies with low DIH is considered as efficient company with less time and less money tied up in inventory.
Days Payable Outstanding
DPO represents number of days a company takes to pay its own outstanding towards supplier invoices. A DPO of 20 means a company takes 20 days to pay to its suppliers. It also indicates for how much time a company is holding its cash before paying off to the suppliers. It is exactly opposite to DSO where increasing of DPO helps in improving CCC which in turn improves the working capital and liquidity of the company. More the DPO, more cash reserve which helps in investments to improve the productivity. But there is also other perspective as low DPO can also make your vendors unhappy and long term business gets affected. Majorly 2 factors drive DPO which are contractual terms with suppliers and the promptness with which company pays its suppliers. Generally its best practice to negotiate best contractual terms with extended credit terms and also easy flexible default terms but then pay to suppliers on time with allowable grace period.
To effectively manage your working capital there are major points, first is to understand the need of managing working capital, second to get the optimum level of working capital where profitability and risks are in level and finally to put the policies of liquidity and profitability in practice.