Working Capital

Working capital is a company’s short term assets, which include cash, inventory, and accounts receivable, minus the short term liabilities, which include accounts payable and short term notes. Short term creditors usually look at the current ratio to determine if a company has the ability to pay off current dept within the agreed terms. The current ratio = current assets / current liabilities and the higher the value, the better for short term creditors. If the current ratio is less than 1, a company may not have the ability to pay the short term liabilities on time which would make it difficult to obtain financing if needed. Organizations should not allow their inventory levels to increase to high level because this would cause a lot of the working capital to be tied up in inventory which is harder to turn into cash if needed. High inventories usually mean several things including that management over estimated sales, had a reduction in sales, or are not controlling operations, which causes a reduction in operating cash flows. We can measure liquidity by the quick ratio which is current assets – inventory / current liabilities. Organizations should plan to keep on hand enough cash to cover all expenses, including payroll, for 3 to 6 months which will allow the ability to withstand the ups and downs in the market without causing great harm to the company.

Some organizations should look at the financial policies and make adjustments to better manage the company’s needs. If a company has notes that are due in the coming year, they should look at ways to increase cash and increase the number of times they turn over the inventory. Some ways that can be used to increase cash which will give more money to pay off short term dept include increasing the long term dept through borrowing, increasing equity through the sale of some stock, increasing current liabilities, decreasing current assets except for cash, and decreasing some fixed assets. Organizations may consider the cash cycle and find ways in which they can decrease the period, which will make the company stronger. A lower cash cycle means that a company has less invested in inventory and receivables which increase the turnover rate. The operating cash flow is one of the best measures to see how well a company is doing and by finding ways which will increase cash, a company will be in a better position to obtain financing or have cash to pay off our short term depts.

Some of the key ratios that should be considered include working capital, current ratio, operating cycle, cash cycle, and the quick ratio. As I have stated, working capital is short term assets which include cash, inventory, and accounts receivable minus the short term liabilities which include accounts payable and short term notes. The current ratio = current assets / current liabilities and the quick ratio is current assets – inventory / current liabilities. The operating cycle is the acquisition of inventory and the collection of cash from receivables: operating cycle = inventory period + accounts receivable period. The operating cycle lets us know how long it takes for a company to convert raw inventory to a product, sell the product, and collect the cash for the product. The cash cycle is the time between cash disbursement and cash collection: cash cycle = operating cycle – accounts payable period. It is good to know the ratios so sound decisions based on accurate information can be made to gain a competitive advantage in the market.

Organizations should maintain a flexible financial policy by managing current assets and current liabilities. By managing cash flows, a company should be able to save money which will increase the profits. Organizations need to be careful not to keep to much cash on hand due to the fact that the cash is not earning money in the bank. Companies also need to watch current assets and current liabilities and find the best combination to increase cash flow. If additional cash is required, companies should know the best sources to raise capital for their needs and how they are going to pay the dept.

J. Taylor