Working capital is the quantity of cash a company has after deducting its current liabilities from its current assets. The greater your business's working capital, all else being identical, the less financial strain it will experience. The key is to ensure that your company uses its working capital in the most efficient manner possible.
Working capital is the cash a company requires to maintain its operations until it is paid by its customers. Working capital is always calculated on a short-term basis; consequently, the short-term goals of working capital are not approached in the same manner as long-term profitability, and working capital management allocates resources according to distinct criteria.
The primary factors are:
cash flow / liquidity and
profitability / return on capital
Cash Conversion Cycle
The most common measure of cash flow is the net operating cycle, also known as the cash conversion cycle. This is the amount of time between making cash payments to suppliers for items needed to produce your products, services, or solutions and receiving payment for sales. The cash conversion cycle reflects your company's capacity to convert resources into currency. You must always strive for a low net count because it effectively represents the amount of time that your company's capital is tied down in operations and unavailable for other activities.
As your business grows, this number will decrease if it becomes more efficient and consistent, and it will increase if it begins to struggle with consistency, making it a very useful indicator of whether or not your business can sustain its products, services, and/or solutions over the long term.
Several methods exist for improving working capital management:
Reduce Operating Cycle Times. Working capital is produced by increased cash flow.
Refrain from financing fixed assets with operating cash.
Conduct credit checks on new clients.
Utilize Trade Credit Insurance.
Reduce unneeded expenditures.
Reduce your bad debt.
Search for additional bank funding.
Using the same context, return on capital employed (ROCE) is the most useful profitability metric. The result is expressed as a percentage and is calculated by dividing the relevant income for the past 12 months by the amount of capital employed; it indicates how effectively your business converts capital into profits.
As stated previously, the value of your business will increase if the return on capital exceeds the expense of capital.
Working Capital Matters
The cash conversion cycle (CCC) is a metric that expresses the number of days required for a business to convert its investments in inventory and other resources into cash flows from sales. Also known as the net operating cycle or simply cash cycle, CCC attempts to determine how long each net input dollar is entangled in the production and sales processes before being converted to cash received.
This metric takes into consideration the amount of time necessary for the company to sell its inventory, collect receivables, and pay its bills.
The CCC formula measures the efficiency with which a company manages its working capital. As with other cash flow calculations, the shorter the cash conversion cycle, the better the company's ability to sell inventory and recover cash while paying suppliers.
The cash conversion cycle should be compared to that of companies in the same industry and conducted in accordance with a trend. Comparing a company's conversion cycle to cycles from previous years, for instance, can help determine whether its working capital management is declining or improving.
In addition, comparing a company's cycle to that of its competitors can help determine whether the company's capital conversion cycle is "normal" in comparison to competitors in the industry.