2025-05-17
Working Capital Management: Optimizing Liquidity and Efficiency
Cash Flow Control: The Art of Working Capital Management
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Why Working capital
management?
In the business world,
investors are often interested in measuring the company’s short term solvency and liquidity besides its long term plans and future
growth prospects. A company has to buy raw materials, pay
salaries, bills, creditors etc. which requires a smooth cash flow. This is
achieved through working capital management.
An efficient
working capital management ensures optimum liquidity
and fuels business activity leading to efficiency.
It makes the manufacturing/production process smooth and efficient and ensures
cordial relations with creditors and customers.
How can a
business ensure an efficient WCM? How can it be tension
free of its bills? How efficient it is in WCM?
Let us
understand what is meant by ‘Working capital management’, how companies can
ensure liquidity and efficiency through an efficient WCM and how efficient is a
company’s WCM.
What is Working
capital and WCM?
Working capital is the difference between
the current assets
and current liabilities of a business.
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Liquid assets
include cash and cash equivalents (e.g. FD’s). Trade receivables include dues from customers, whereas
trade payable refers to money owed to creditors.
A positive
working capital indicates sufficiency of assets to meet liabilities whereas a negative working
capital shows deficit.
However a higher
surplus may indicate
that the company’s assets are
underutilized.
Working capital management refes to overseeing and controlling the current assets and liabilities of a company to ensure liquidity
to meet day to day expenses and ensure
efficiency in business operations.
WCM involves
the following:
1. Liquidity management:
Ensuring sufficient to cash to meet its day to day expenses and maintaining sufficient reserves to tackle
any future contingencies or capital needs.
2. Inventory management: Ensuring
optimum levels of stock and sale to avoid underutilization.
3. Accounts receivable and payable: Negotiating favorable terms from creditors
and faster collection from debtors to reduce cash conversion cycle.
4. Short term financing:
Investing in short term instruments like commercial papers, short term loans,
etc. to finance short term obligations and needs.
Requirement
of working capital depends upon the industry to industry and type of business. A retail business
or a company that has seasonal or fluctuating demand will
have low working capital whereas manufacturing companies usually have higher
demand for working capital due to long receivable cycle.
How can companies ensure
an efficient WCM?
As an
entrepreneur you must have an efficient WCM so that you pay your daily bills
and your employees get their monthly wages. Let us look at several ways by which a business can improve its
WCM efficiency:
1. Accelerating accounts
receivables:
This may involve
providing discounts on early payments, automating collection
systems, digitizing invoicing, and maintain cordial relations over a long
period with customers.
2. Tightening accounts payable:
This involves negotiating favorable
terms with creditors, taking
advantage of early payment discounts, etc. Effective communication and
relationship building is the key here.
3. Reduce operating costs:
The business must identify areas where it can cut costs. It may be as in getting quality
raw material at low costs,
use of new tech, automated ERP’s etc.
4. Cash flow forecasting and scenario
planning: The Company shall accurately forecast cash flow requirements by analyzing historical and relevant data.
Also it must forecast cash requirements for any future
contingencies and make provisions.
5. Improved Inventory Management:
It shall ensure that only sufficient stock is bought by chalking the necessary
requirements. Also inventory turnover and other relevant factors must be checked
on periodic basis to find reason for excess inventory.
6. Consider several financing options: A business shall consider several
short term investment to options such as CP’s,
loans, bonds, etc. to finance
its short term liabilities. Diversification
of investments will ensure timely liquidity and mitigating financial risk.
7. Optimum use of technology: A business shall get hands on
sophisticated tech to ensure better cash flow forecast and enhanced liquidity.
Use of AI and Machine learning for repetitive tasks
such as data entry, report
generation helps save time and cost.
Better cash flow forecasting and treasury softwares
enable businesses to keep track of their solvency and cash requirements.
Also it enables them to get relevant
and timely data for forecasting. The business shall invest in a software or ERP system
that reduces costs and time and improves efficiency. For e.g. Oracle, SAP, etc.
How to measure WCM efficiency?
As a value
investor, get interested in knowing how your company manages its daily cash needs.
Imagine you invest
in a company that has a fair valuation, profits
growing with good CAGR initially and so on, but later its short term debts and cash conversion
cycle rises. It is a sign that the company struggles in meeting daily cash
needs. Companies consider several metrics to measure its WCM efficiency in
order to keep track of daily cash needs:
1. ?Current ratio
It measures
the solvency position
of the company and is calculated by dividing current assets with current liabilities.
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A ratio lower than 1 indicates
inability to meet short term obligations or liquidity deficits. A ratio of 2:1 is considered as
ideal for solvency but higher may indicate underutilization of assets.
2. Quick Ratio (Acid-Test)
The quick
ratio refines the current ratio by excluding inventory. This ratio is
particularly useful for businesses where inventory can't be easily
sold for cash when
needed. A quick ratio above 1.0 generally signifies a company has good short
term solvency.
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3. ?Cash conversion cycle
It is the
duration within which money invested in inventory gets converted back into cash
after sale. It enables a business to know how much time money is blocked in
inventory till it sold. It is measured as following:
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