An organization’s working capital is the difference between its current assets and current liabilities. Although the optimal amount of working capital varies depending on the industry and the nature of operations, organizations need a certain amount of working capital to run their operations smoothly. And if working capital management is inefficient, it can hinder performance and growth.
Measuring liquidity
An item’s “liquidity” is the measure of how quickly the item can be converted to cash. Generally speaking, receivables are considered to be more liquid than inventory. The following liquidity metrics are commonly used to evaluate working capital:
Current ratio: To calculate the current ratio, current assets are divided by current liabilities. A current ratio of 1.0 or higher indicates that the company has enough available current assets to cover any liabilities due within 12 months.
Quick (or acid-test) ratio: This more conservative liquidity benchmark usually excludes inventory and prepaid assets from the calculation.
You can also evaluate working capital by comparing it to an organization’s total assets and annual revenues—viewed from this perspective, working capital can be used to measure operating efficiency. If an excessive amount of cash is tied up in working capital, it can prevent an organization from pursuing other spending options, such as buying equipment, paying down debt, and expanding into new markets.
Improving working capital efficiency
Having high liquidity usually indicates low financial risk. However, if your working capital is consistently increasing year after year or is significantly higher than competitors’ working capital, you may have too much of a good thing. If your liquidity is higher than needed, you may want to consider taking certain steps to speed up cash inflows and slow down cash outflows.
In order to realize more efficient operations, each component of working capital should be analyzed and these best practices should be implemented:
- Cash should be put to good use. Having too much cash on hand can cause management to grow complacent about working capital. If your organization has cash to spare, you might have less incentive to collect receivables and stay disciplined about ordering inventory.
- Speed up collections. Selling on credit effectively finances customers’ operations. Stale receivables—such as any balance over 45 or 60 days outstanding, depending on the industry—are a sign that your working capital management could be more efficient.
To better handle receivables, you should start by taking stock of which items can be written off as bad debts. Viable balances then need to be “talked in the door” as quickly as possible. You may also want to use electronic invoices, early bird discounts,and collections-based sales compensation programs to enhance collections efforts.
- Keep less inventory on hand. Inventory is a huge investment for manufacturers, retailers, distributors, and contractors, and it can be difficult to value and track. Using enhanced forecasting and data sharing with suppliers can make it less necessary to keep a safety stock and allow you to implement smarter ordering practices. You can also improve your inventory tracking and ordering practices by using computerized technology like barcodes, enterprise resource planning tools, and radio frequency identification.
- Extend credit terms. Payments should be postponed as long as possible—as long as you aren’t losing out on early bird discounts. Extending your organization’s average days in payables (for example, from 45 to 60 days) trains suppliers and vendors to accept the new terms, especially if you’re a reliable, predictable payor.
Contact us for help
When organizations become too focused on their income statement, they can lose sight of the strategic value of their balance sheet—especially when it comes to working capital accounts. We can help you measure your organization’s liquidity and asset efficiency over time and in comparison to your competitors. If needed, we also can help you implement strategies to improve performance while avoiding any unnecessary risk.