Working Capital Management
Why Working Capital Is Important?
Working capital is one of the main parts of company’s finances and every manager, even of the small company, manages working capital despite the fact he knows about that or not. To simply describe working capital we could use a comparison that working capital for the company is similar to the blood for the body.
Why it is so important that every CFO of the company speaks all the time about working capital and its management? The answer is simple: the higher is working capital the more funds are needed for that. Money can be raised either as equity capital either as debt capital but in any case capital has its costs. That means working capital also has its costs. To make it more clearly, we can think of simple example: company’s manager could invest in some new equipment that would save him energy expenses but he has no free funds because all possible funds are needed for working capital. If he could lower net working capital he would have free cash to invest in that equipment and earn higher profit.
What Is Working Capital?
Working capital definition: working capital is a type of capital that is used to sustain company’s activity at healthy level and is equal to current assets less current liabilities*.
Press the link if want to know more about calculation of this indicator: *working capital calculation. Before calculating working capital you should know that there are few modifications of the calculation and some of them are more common while others more modern.
Most of the companies have positive working capital, however, negative working capital is also possible for businesses that receive their receivable very quickly but may delay in payments and do not have much of inventory. An example of such business can be advertising and consulting businesses.
Working capital may mean few additional things despite the fact that it is necessary for the company to continue activity. One of these things is management efficiency: if company has much more working capital than it is needed, it may mean that company’s management does not a good job. In other hand, if financial analysis of the company indicates that company’s working capital is significantly lower than should be, it may indicate that company has significant financial problems, of course, if other ratios used for solvency analysis as Debt to EBITDA, EBITDA Coverage Ratio or Debt to Equity confirm such problems as possible.
Working Capital and Value of Stocks
In approach of company’s value as an investment working capital may mean few things. A lot of working capital increases the value of company’s stocks but only in that case if working capital could be realized together with other assets and such assets would be worth more than the price paid for stocks (or market capitalization).
But if value of working capital is not very significant compared to the total market value, then large working capital will not add much of a value, especially if some growth of the business is incorporated in the valuation. In that case growth would require much more investments in working capital.
Change in Working Capital
Changes in working capital may tell a lot for financial analysts. If working capital is changing quickly or is too low or too high, it may indicate several things:
- Company has troubles to manage its working capital efficiently.
- Company’s business or business style is changing.
- The scale of business is changing.
- Company is facing real financial problems.
But to analyze working capital correctly, few rules must not be forgotten:
- For comparison working capital ratio (working capital to sales) should be used but not the total working capital which mostly depends on the scale of a business.
- Different businesses have different working capital ratio so it is very important that compared firms would be identical and would work in the same industry niche.
- Many businesses are seasonal and that means that working capital is changing over the seasons. It is important that changes of working capital would not include the seasonal changes. Because of that the same seasons should be compared.
Working Capital Management
The management of working capital requires management of each part separately:
- Inventory management requires continuing monitoring of inventory levels and each type of inventory should be lowered till reaches necessary level. Most of the inventories may depreciate in time if not physically then morally and this is another reason to handle inventories efficiently.
- Receivables management includes monitoring of receivables and work with clients trying to get receivables from them faster as possible. Every delay in receivables increases working capital. Be sure that you sending invoices in time and trying to get prepayments if they are normal at this type of business. 'Receivable turnover ratio' is one of the main ratio for receivables management efficiency measurement.
- Payables management includes monitoring of payable amounts to the suppliers and work with them trying to get contracts that do not require fast payments.
Every manager knows that working capital management is important for the company and helps to maximize shareholders wealth, but over-trying to manage working capital can be damaging. Just imagine the situation when one company is supplier and another company is client (in reality all companies are someone’s suppliers and clients). And the supplier is pushing the client to pay faster when client is trying not to pay as long as possible. If such situation would go too far they simple would not like to work together; however, it may be that a good client or supplier is better that little more efficiency in working capital management…