The efficient management of working capital is essential for the profitability and overall financial health of any company. Working capital is the cash that companies use to operate and conduct their businesses.
The aspects of working capital that investors and analysts assess to evaluate a company are the key elements for a company’s cash flow – money coming in, money going out and management of inventory. This helps ensure that a company always maintains sufficient cash flow to meet its short-term operating costs and short-term debt obligations.
These are three main components associated with working capital management:
1. Accounts Receivable
Accounts receivable are revenues due – what is owed to a company by its customers for sales made. Timely, efficient collection of accounts receivable is essential to a company’s smooth financial operation.
Accounts receivable are listed as assets on a company’s balance sheet, but they are not actually assets until they are collected. A common metric analysts use to assess a company’s handling of accounts receivable is days sales outstanding, which reveals the average number of days a company takes to collect sales revenues.
2. Accounts Payable
Accounts payable, the money that a company is obligated to pay out over the short term, is also a key component of working capital management. Companies seek to strike a balance between maintaining maximum cash flow by delaying payments as long as is reasonably possible and the need to maintain positive credit ratings while sustaining good relationships with suppliers and creditors. Ideally, a company’s average time to collect receivables is significantly shorter than its average time to settle payables.
Inventory is a company’s primary asset that it converts into sales revenues. The rate at which a company sells and replenishes its inventory is an important measure of its success.
Investors consider the inventory turnover rate to be an indication of the strength of sales and as a measure of how efficient the company is in its purchasing and manufacturing process. Inventory that is too low puts the company in danger of losing out on sales, but excessively high inventory levels represent wasteful, inefficient use of working capital.