The attributes of working capital
The attributes of working capital
The attributes of working capital
An important tool companies adopt to send a message to the investors that the company means business is to cut capital expenditure and reduce non-core assets. Usually this is met with more investment or better stock price from the market. What is the message that the investors are receiving that entices such a reaction? Usually, the message means that the company is trying to reduce cost and become more efficient. They are indicating that the company is trying to get more assets available that they can use for operational expenses in the short term for their financial health. In financial metrics this means increasing the current assets or decreasing current liabilities.
A good measure to identify this is the Working Capital (WC).
Working Capital = current assets - current liabilities.
Current assets are cash and other assets that can be converted to cash within a year. Current liabilities are obligations that the company plans to pay off within the year. Working capital indicates the assets the company has at its disposal for current expenses. It can be thought as the circulating capital of a business. The process of managing the WC efficiently is called Working capital Management. It's one of the important aspects of financial management. An excess of working capital many mean that the company is not managing its assets efficiently. It's not using its assets to get a bigger return or better profit. An aggressive company may keep its working capital smaller. A very low working capital may mean the company may not be suited well enough to payoff its short term obligations.
This decision of how to manage the working capital of the company depends on the Working capital policy of the company. An important factor that determines the policy is the industry in which the company operates. For Example, an IT service company may not have a lot of shot-debt in terms of inventory but it still needs to pay wages, insurances and other expenses like rent. The company needs to have a policy that makes sure it sets targets were it gets paid as the project progresses so it can keep paying its staff in time. The company has to manage its account receivables according to this policy. Some industries operate in a high profit margin that they can afford to have a longer term on the account receivables because the higher cash balance part of the current assets. A good example is a company like BP, which is able to survive till now after the big oil spill disaster in the Gulf.
The Collection Ratio helps project this aspect of a company
Collection Ratio = Accounts Receivable/ (Revenue/ 365)
Collection ratio tells us the average number of days it takes a company to collect unpaid invoices. A ratio which is very near to 30 days is very good since it means that the company is getting paid on a monthly basis.
Cutting costs and shedding non-essential assets to make the company leaner is one of the attributes of working capital management. But this strategy cannot be sustained. The company cannot keep cutting costs without sacrificing service. Once the company becomes lean enough cutting costs will become detrimental to its operations.
Another attribute that strongly impacts working capital is sales. It is the ability of a company to sell its products fast enough to get the money back to put back into operations or supplies for producing more materials. Moving inventory fast is always a good plan for a company. It also helps in reducing costs associated with holding and moving inventory. A good ratio that helps put the attribute in perspective is inventory turnover ratio.
Inventory turnover ratio= sales / inventory
Alternatively,
Inventory turnover ratio = Cost of goods sold / inventory
The ratio shows the efficiency the company has in selling its products. The higher the ratio the better the company is able to move the products. Again this could be dictated by the industry, for example, a daily products company is usually forced to sell its products fast enough or lose it. The ratio also provides a good insight into how a company is doing within an industry. The direct ratio of companies can be compared to see how well the company is able to sell the products in comparison to its competitors.
Financing is another attribute of Working Capital management. Companies tend to finance their way out of a need for short term expenses by taking loans. From the balance sheet it is clear that financing increases liabilities, so the only option companies have to increase Working capital is though long-term debts that have a smaller impact on current liabilities. This way their short term cash balance increases providing the cushion the company needs for its short-term operating needs. Since obtaining long term debt depends on the credit rating of the company it becomes difficult for smaller or newer companies to use this attribute of working capital management.
Debt-Asset ratio provides a good insight into how much of the company's assets are being financed though debt
Debt-asset ratio = Total liabilities / Total assets
Financing for short term operations may not immediately signal an issue with the company, it may be that the company has realized an opportunity that it needs to act on immediately which would increase the prospects of the company in the long term. Companies that have an aggressive working capital management policy would be using this strategy. But this is always riskier since the company would accumulate a lot of long-term debt that could eat away at the profits or even become so big that the interest expense can impact the current liabilities.
Working capital management becomes a very important aspect for a company since it is the first line of defense against market downturn cycles and recession. A company with cash is usually in a good position to make better use of the opportunities the markets provide. Its can spend the money on R&D for coming up with better products. Increase in current assets, especially, increase in account receivables due to growth is sales have to be managed efficiently. Ability to control working capital plays a significant role in the survival of the company.
Advertising Pr Jobs - Tips For Seeking Out Pr Opportunities The Advantages Of Professionally Managed Hr Jobs In Pr - 7 Steps To Success In Pr Jobs Event Planning Careers - Future Of Event Planning Profession Event Planning Training - How To Get A Job In Event Planning Career Employment - How To Handle Job Vacancies The Wonders of Having Professional SEO Services Temporary Jobs In Amsterdam Weekend Jobs: Options for the Jobless People Important Advice On Selecting A Professional Seo Company Why Choose Professional Scuba Dive Training in Vancouver? How To Choose The Right Tipping Semi Trailers To Get The Job Done How to Heal Skin Problems - Looking For the Best Possible Ingredients to Do the Job Effectively?