2 Working Capital Management Components and Working Capital Requirements

2 Working Capital Management Components and
working capital requirements

2.1 Working Capital Management Components
GOAL: Working capital is a key metric used to measure a company's
short-term financial health and well-being. It is the difference between a
company's current assets and current liabilities. As such, it is the capital
that is left after accounting for its current liabilities. Working capital
management is a strategy that companies use to manage their leftover
cash.
Certain balance sheet accounts are more important when considering

working capital management. Though working capital often entails
comparing all current assets to current liabilities, there are a few
accounts that are more critical to track.
Cash
The core of working capital management is tracking cash and cash

needs. This involves managing the company's cash flow by forecasting
needs, monitoring cash balances, and optimizing cash flows (inflows and
outflows) to ensure that the company has enough cash to meet its
obligations.
Because cash is always considered a current asset, all accounts should

be considered. However, companies should be mindful of restricted
or time-bound deposits.
Receivables
To manage capital, companies must be mindful of their receivables. This

is especially important in the short term as they wait for credit sales to be
completed. This involves:
 Managing the company's credit policies

 Monitoring customer payments
 Improving collection practices
At the end of the day, having completed a sale does not matter if the
company is unable to collect payment on the sale.
Account Payables
Account payables refers to one aspect of working capital management

that companies can take advantage of that they often have greater
control over. While other aspects of working capital management may be
uncontrollable, such as selling goods or collecting receivables,
companies often have a say in how they pay suppliers, what the credit
terms are, and when cash outlays are made.
Inventory
Companies primarily consider inventory during working capital

management as it may be the most risky aspect of managing capital.
When inventory is sold, a company must go to the market and rely on
consumer preferences to convert inventory to cash.
If this cannot be completed quickly, the company may be forced to have

its short-term resources stuck in an illiquid position. Alternatively, the
company may be able to quickly sell the inventory but only with a steep
price discount.
2.2 working capital requirements
Working capital requirements of firms consists of 2 types: Regular necessary

WC requirement and short-term WC requirement (not regularly).
With this conception, working capital requirements is determined by formula:
WCR = Receivables from customers + Inventory – Payable to suppliers
In which:
Receivables = Average daily revenues x Days of sales outstanding
Inventory = The average daily amount of x Inventory

consumption for capital rotation period
Or WCR = Mn x N
3 Working Capital Management Ratios
Three ratios that are important in working capital management are the
working capital ratio, the collection ratio, and the inventory turnover ratio.
3.1 Working Capital 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.
A 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.
Working 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.
Below 1.0 Company may not meet its short-term obligations
1.2 to 2.0 Company has more current assets to current liabilities
Above Company isn't using assets effectively to increase revenue

2.0
Why Is the Current Ratio Important?

The current ratio or the working capital ratio indicates how well a firm
can meet its short-term obligations. It's also a measure of liquidity. If a
company has a current ratio of less than 1.0, this means that short-term
debts and bills exceed current assets, which could be a signal that the
company's finances may be in danger in the short run.
3.2 Collection Ratio (Days Sales Outstanding)
The 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.2
The 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.
Why Is the Collection Ratio Important?

The collection ratio, also known as days sales outstanding, is a measure
of how efficiently a company can collect on its accounts receivable. If it
takes a long time to collect, it can be a signal that there will not be
enough cash on hand to meet near-term obligations. Working capital
management tries to improve the collection speed of receivables.
3.3 Inventory Turnover Ratio

Another 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.3
.
The 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.3
Why Is the Inventory Ratio Important?

The inventory turnover ratio shows how efficiently a company sells its
inventory. A relatively low ratio compared to industry peers indicates a
risk that inventory levels are excessively high, while a relatively high ratio
may indicate inadequate inventory levels.
4 Cash management
Cash is the most important current asset and is considered as the
“lifeblood” of a business, helping the business running in a continuous basic.
The term cash includes currency, checks and balance in back accounts.
Costs of Holding Cash
 William Baumol developed a cash model to determine the optimum
amount of transaction cash under conditions of certainty. The optimal level of
cash is determined using the following formula:
ECL = √ 2 CF
O
In which:
ECL = Economic Conversion lot or Optimum Cash Balance
C = Cost per conversion
F = Projected cash requirements during the planning period
O= interest rate per planning period on investment in marketable securities
The Miller – Orr Model

 Determining optimal cash balance under conditions of uncertainty:
RP = √
3 3 b σ2
4i
+ LL
UL = 3RP – 2LL
In which:
RP = return point
b = fixed cost per order for converting marketable securities into cash.
i = daily interest rate earned on marketable securities
 2 = variance of daily changes in the expected cash balance

LL = the lower control limit
UL = the upper control limit
 The goal of cash management is (1) to maintain an adequate level

of cash on hand to meet the daily cash requirement in operation and (2)
maximize the amount of money that are available for investments and obtain
the maximum of interest earned on excess cash while ensuring the safety.
The optimal cash balance depends on the following factors:
 The forecasts of future cash inflows and outflows of companies.

 The efficiency of the firm’s cash flow management.
 The availability of liquidity assets to the firms.
 The company’s borrowing capacity.
 The company’s tolerance of risk.

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2 Working Capital Management Components and

working capital requirements

Certain balance sheet accounts are more important when considering

The core of working capital management is tracking cash and cash

Because cash is always considered a current asset, all accounts should

To manage capital, companies must be mindful of their receivables. This

 Managing the company's credit policies

Account payables refers to one aspect of working capital management

Companies primarily consider inventory during working capital

If this cannot be completed quickly, the company may be forced to have

2.2 working capital requirements

Working capital requirements of firms consists of 2 types: Regular necessary

With this conception, working capital requirements is determined by formula:

WCR = Receivables from customers + Inventory – Payable to suppliers

Receivables = Average daily revenues x Days of sales outstanding

Inventory = The average daily amount of x Inventory

3.1 Working Capital Ratio

The working capital ratio or current ratio is calculated by dividing current

Working capital ratios of 1.2 to 2.0 are considered desirable as this

Below 1.0 Company may not meet its short-term obligations

1.2 to 2.0 Company has more current assets to current liabilities

Above Company isn't using assets effectively to increase revenue

Why Is the Current Ratio Important?

3.2 Collection Ratio (Days Sales Outstanding)

The collection ratio, also known as days sales outstanding (DSO) , is a

The collection ratio calculation provides the average number of days it

Why Is the Collection Ratio Important?

3.3 Inventory Turnover Ratio

Why Is the Inventory Ratio Important?

The Miller – Orr Model

 2 = variance of daily changes in the expected cash balance

 The goal of cash management is (1) to maintain an adequate level

 The forecasts of future cash inflows and outflows of companies.

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