Proper use of working capital is vital in an organization’s financial health in its business. Capital management is the use of accounting strategies to maintain sufficient levels of working capital, current liabilities, and current assets. The main idea is to ensure that the firm maintains a good ration of the firm’s assets and liabilities. Through the use of working capital management firms can meet their obligations in terms of expenses while ensuring that they have a steady cash flow due to the company’s financial decisions. This enables them to maintain a proper balance between liquidity, growth, and profitability. An organization’s working capital is comprised of its current assets and its current liabilities. When proper capital management is employed in the right manner, the organization is guaranteed an increase in its financial levels unless the organization is at its maximum efficiency.
Importance of Working Capital Management
Management of working capital ensures that the company’s earnings are profitable and are efficiently used to ensure that the company is covered from debt and maximizing its return on assets investment. Accounts payables, inventory management, and accounts receivables are part of working capital management. Working capital management enables companies to optimize their operational efficiency. Working capital management aims to ensure that there is constant working capital for the operational costs of the company and ensuring that it maximizes the return on current investment assets. Financial insolvency is a result of inefficient working capital management, which results in bankruptcy and liquidation of assets, which is poor management of wealth. Proper management of inventories enables companies to identify areas that require improvement to maintain profitability and liquidity.
Working capital management ratios
This helps the company assess its financial health by its ability to attain its short-term financial responsibilities. The current ratio is measured by calculating a company’s existing assets divided by its current liabilities. If a company’s ratio is below 1.0, then it has trouble achieving its short-term financial obligations, which can be sorted by seeking capital investment in the form of loans from financial institutions. On the other hand, a ratio of 2.0 dictates that the company is not using its working capital efficiently.
This measures how efficiently an organization manages its accounts receivable. Collection ration is calculated as the product of the number of days in the accounting period that is multiplied by the average sum of the outstanding accounts receivables divided by the number of net credit sales during that accounting period. Through the use of collection ration management, it allows companies to estimate the number of days it will take them to receive payment after a credit sale. If a company has a low collection ratio, then the company will have efficiently managed its cash flow.
Inventory Turnover Ratio
Inventory management enables organizations to maintain and operate efficiently with the available working capital to have enough inventories to meet its customers’ needs avoiding excess inventory that limits working capital. Inventory turnover is calculated by dividing revenue by inventory cost to learn how the company is efficiently running. When a company has a high ratio, it denotes that the company has inadequate inventory levels. In contrast, a low ratio rate indicates that the organization has high levels of inventory that are using up capital investments that can be used up elsewhere.