why manage working capital 
working capital management can improve a company s cash flow management and earnings quality through the efficient use of its resources management of working capital includes inventory management as well as management of accounts receivable and accounts payable working capital management also involves the timing of accounts payable like paying suppliers a company can conserve cash by choosing to stretch the payment of suppliers and to make the most of available credit or may spend cash by purchasing using cash these choices also affect working capital management in addition to ensuring that the company has enough cash to cover its expenses and debt the objectives of working capital management are to minimize the cost of money spent on working capital and maximize the return on asset investments 1working capital management ratiosthree ratios that are important in working capital management are the working capital ratio the collection ratio and the inventory turnover ratio the working capital ratio or current ratio is calculated by dividing current assets by current liabilities this ratio is a key indicator of a company s financial health as it demonstrates its ability to meet its short term financial obligations 2a working capital ratio below 1 0 often means a company may have trouble meeting its short term obligations that s because the company has more short term debt than short term assets to pay all of its bills as they come due the company may need to sell long term assets or secure external financing 2working capital ratios of 1 2 to 2 0 are considered desirable as this means the company has more current assets compared to current liabilities however a ratio higher than 2 0 may suggest that the company is not effectively using its assets to increase revenues for example a high ratio may indicate that the company has too much cash on hand and could be more efficiently utilizing that capital to invest in growth opportunities 2the collection ratio also known as days sales outstanding dso is a measure of how efficiently a company manages its accounts receivable the collection ratio is calculated by multiplying the number of days in the period by the average amount of outstanding accounts receivable this product is then divided by the total amount of net credit sales during the accounting period to find the average amount of average receivables companies most often simply take the average between the beginning and ending balances 2the collection ratio calculation provides the average number of days it takes a company to receive payment after a sales transaction on credit note that the dso ratio does not consider cash sales if a company s billing department is effective at collecting accounts receivable the company will have quicker access to cash which is can deploy for growth meanwhile if the company has a long outstanding period this effectively means the company is awarding creditors with interest free short term loans 2another important metric of working capital management is the inventory turnover ratio to operate with maximum efficiency a company must keep sufficient inventory on hand to meet customers needs however the company also needs to strive to minimize costs and risk while avoiding unnecessary inventory stockpiles 3the inventory turnover ratio is calculated as the cost of goods sold cogs divided by the average balance in inventory again the average balance in inventory is usually determined by taking the average of the starting and ending balances the ratio reveals how rapidly a company s inventory is used in sales and replaced a relatively low ratio compared to industry peers indicates a risk that inventory levels are excessively high meaning a company may want to consider slowing production to ease the cost of insurance storage security or theft alternatively a relatively high ratio may indicate inadequate inventory levels and risk to customer satisfaction 3working capital cyclein addition to the ratios discussed above companies may rely on the working capital cycle when managing working capital working capital management helps maintain the smooth operation of the net operating cycle also known as the cash conversion cycle ccc this is the minimum amount of time required to convert net current assets and liabilities into cash the working capital cycle is a measure of the time it takes for a company to convert its current assets into cash or the working capital cycle represents the period measured in days from the time when the company pays for raw materials or inventory to the time when it receives payment for the products or services it sells during this period the company s resources may be tied up in obligations or pending liquidation to cash the inventory cycle represents the time it takes for a company to acquire raw materials or inventory convert them into finished goods and store them until they are sold during this stage the company s cash is tied up in inventory though it starts the cycle with cash on hand the company agrees to part ways with working capital with the expectation that it will receive more working capital in the future by selling the product at a profit the ar cycle represents the time it takes for a company to collect payment from its customers after it has sold goods or services during this stage the company s cash is tied up in accounts receivable though the company can part ways with its inventory its working capital is now tied up in accounts receivable and still does not give the company access to capital until these credit sales are received the ap cycle represents the time it takes for a company to pay its suppliers for goods or services received during this stage the company s cash is tied up in accounts payable on the positive side this represents a short term loan from a supplier meaning the company can hold onto cash even though they have received a good on the negative side this creates a liability that needs to be managed limitations of working capital managementwith strong working capital management a company should be able to ensure it has enough capital on hand to operate and grow however there are downsides to the approach working capital management only focuses on short term assets and liabilities it does not address the long term financial health of the company and may sacrifice the best long term solution in favor of short term benefits even with the best practices in place working capital management cannot guarantee success the future is uncertain and it s challenging to predict how market conditions will affect a company s working capital whether there are changes in macroeconomic conditions and customer behavior or there are disruptions in the supply chain a company s forecast of working capital may simply not materialize as expected while effective working capital management can help a company avoid financial difficulties it may not necessarily lead to increased profitability working capital management does not inherently increase profitability make products more desirable or increase a company s market position companies still need to focus on sales growth cost control and other measures to improve their bottom line as that bottom line improves working capital management can simply enhance the company s position 