Working capital is actually the difference between company’s current assets and current liabilities and it is a very important financial ratio showing the company’s liquidity and efficiency. The current assets (reported on the balance sheet) include cash, accounts receivable and prepaid expenses.
On the other hand, current liabilities are paid either by the current assets or by creating a new current liability. Current liabilities (reported on the right side of the balance sheet) include accounts payable, notes payable, tax payable and short-term debt.
The term current generally means within the next 12 months or within the current fiscal year or current operating cycle for the company, so it may vary between different organizations. However the main point is the current assets and current liabilities as well as working capital are generally about short-term – period not longer than the next 12 months.
Working capital management as a business strategy and tactic makes sure that the organization has the ability to pay its current liabilities with its current cash flow. By using financial ratio analysis, owners, management and other decision makers can analyze its current financials, cash flow and operating expense structure of the company and identify alternative ways for improving and better managing the working capital.
In addition to financial ratio analysis each of the individual components must be analyzed and managed on its own.
For example, ratio analysis deals with analysis of the correlation and relationships between the financial numbers from your financial statements (income statement, balance sheet and cash flow statement) – while ratios are very important for financial management, it is also crucial for each of the individual components to be improved.
For example, the current ratio may looks good but by improving the cash flow or cutting the current debt it can be even further improved.
Frequently used ratios in working capital management are working capital ratio (current assets – current liabilities) and the collection ratio. In addition for organizations selling physical products and carrying inventories the inventory turnover and some other important inventory metrics can be used to identify additional ways for better managing working capital.
When current assets are not sufficient to cover the current liabilities, the organization is not able to pay its short-term debt and payables with its current cash.
The alternatives include (A) improving the current assets through better inventory management and better collection practices and / or (B) adding additional current debt to the balance sheet and develop better working capital strategies and approaches for the long-term.
Management should always focus its efforts on managing certain levels of working capital. This means that there must be a certain level of current assets as well as current liabilities maintained at anytime.
Not having sufficient working capital is not necessary a bad thing for the company – most business organizations, both small and large companies, will need an additional working capital at some point in time in order to act in response to important short-term issues and take advantage of potential new opportunities and there are many ways to raise additional capital or borrow short-term debt.