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Define Working Capital - PDF


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									Working Capital Management
In the current recessionary environment, where traditional sources of financing have been
constricted, strict attention to working capital management is of paramount importance to
organizations of all sizes and financial condition. Indeed, in a world where “cash is king,” it is
important that a working capital management program be properly aligned with an organization’s
overall business strategy and goals. This requires an organization to implement processes and
related tools to measure, and thereby monitor, the components of working capital.

In our continuing series of communications related to Corporate Renewal, we define working capital
and the goal of working capital management; and discuss techniques for both measuring and
monitoring the key components of working capital.

Working Capital Defined
Working capital is defined as Current Assets minus Current Liabilities. While this textbook
definition of working capital encompasses certain assets and liabilities that are expected to be
consumed, converted into cash, or settled in cash within the next year (e.g. such as prepaid expenses
and accrued liabilities), the typical components of working capital that are aggressively managed
       Accounts Receivable;
       Accounts Payable; and
       Short-term debt

It is important to understand that routine business activities (or “cycles”) either generate or consume
working capital. For example, in a manufacturing organization, the following inter-related and
concurring “cycles” generate and consume working capital:
       Inventory (in raw material form) is purchased from suppliers on short-term (trade) credit,
       creating Accounts Payable (Procure-to-Pay Cycle)
       Inventory is converted from raw materials into finished goods (Inventory Cycle)
       Inventory (in finished goods form) is sold to customers on short-term (trade) credit, creating
       Accounts Receivable (Order-to-Cash Cycle)
       Suppliers are paid in cash, reducing Accounts Payable and reducing Cash (Procure-to-Pay
       Customers remit payment, reducing Accounts Receivable and increasing Cash (Order-to-
       Cash Cycle)

MPP&W, P.C. | 1034 S. Brentwood Blvd., Suite 1700 | St. Louis, MO 63117 | (314) 862.2070 | www.mppw.com
The Goals of Working Capital Management
The principle goal of Working Capital Management is to ensure that an organization generates
sufficient positive working capital (specifically in the form of Cash) from ongoing business activities
to continually fund both debt payments and operating expenses.

As illustrated above, the effective management of working capital involves managing discrete, but
highly inter-related processes (cycles). Since these processes are interrelated, decisions made within
each one of the disciplines can impact the other processes, and ultimately affect an organization’s
overall financial performance.

Measuring and Monitoring Work Capital
There is the perception within many organization’s that you cannot effectively predict when cash
will be collected or when it will need to be disbursed. In reality, analyzing statistics (i.e. metrics) for
individual components of working capital often yields patterns or trends that enable managers to
reasonably forecast sources and uses of cash.

This approach is most effective when:

    1. It is applied across appropriately identified segments of a business (for example, by “classes”
       of customers, inventory items (SKUs), and vendors/suppliers); and
    2. Results are benchmarked against industry averages, your own organization’s historical
       performance, and/or your immediate competitors (to the extent that such information is

Following are several metrics used to assess performance of various components of working capital:

    Current Ratio (CR): Total Current Assets / Total Current Liabilities.
    The CR is used primarily to determine a company's ability to pay back its short-term liabilities
    (debt and payables) with its short-term assets (cash, inventory, accounts receivable). The higher
    the current ratio, the more capable the company is of paying its obligations.

    Quick Ratio (QR): (Total Current Assets – Inventory) / Total Current Liabilities
    Also known as the “acid test ratio,” the QR predicts your immediate liquidity more accurately
    than the current ratio because it takes into account the time needed to convert inventory to cash.

    Inventory Turnover Ratio (ITR): Cost of Goods Sold / Average Value of Inventory.
    The ITR indicates how quickly inventory is turning. A low turnover ratio often implies poor
    sales, and therefore, excess inventory. A high ratio suggests strong sales or ineffective buying.
    Frequently it is a good idea to evaluate the ITR by inventory class or subgroup to better
    understand the underlying causes that contribute to the overall ITR results.

MPP&W, P.C. | 1034 S. Brentwood Blvd., Suite 1700 | St. Louis, MO 63117 | (314) 862.2070 | www.mppw.com
    Receivables Turnover Ratio (RTR): Net Sales / Receivables.
    The RTR indicates how quickly your customers are remitting payment for products/services
    sold to them. A high ratio implies that an organization is efficient in collecting accounts
    receivable (perhaps due to strict credit terms). A low ratio suggests that an organization should
    re-assess its credit policies and collection practices.

    Payables Turnover Ratio (PTR): Cost of Goods Sold / Payables.
    The PTR is an indicator of how quickly you are paying your suppliers. A higher PTR (compared
    to industry averages) may be appropriate if you are earning discounts for quicker payment.
    Analyzing your PTR by individual supplier or by types of suppliers can help identify potential

In summary, gaining an understanding of the current situation for use of working capital can help
identify opportunities to make needed changes in strategy or processes to help improve working
capital results. Frequently the opportunities are readily identified and needed action plans may be
quickly developed after gaining an understanding of the current situation.

About MPP&W, P.C.
MPP&W, P.C. is a team of CPAs and business advisors headquartered in St. Louis. The firm offers a
full range of professional tax, audit, accounting and management advisory services to businesses and
high-net worth individuals.

MPP&W, P.C.’s Corporate Renewal Services team provides integrated solutions to underperforming
and financially distressed companies. In addition to corporate finance and crisis management
serviced offered by traditional “turnaround” specialists, MPP&W’s Corporate Renewal Services
delivers management advisory services in areas such as enterprise risk assessment; benchmarking;
strategic and tactical planning; financial modeling; and process transformation. These services are
delivered by cross-functional teams with skills in various disciplines including six sigma; lean
manufacturing; activity-based costing; business valuation; and data mining.

Our Corporate Renewal Services team can assist companies at all stages of their life cycle
and financial health. For additional information or to learn how our Corporate Renewal Services
team can assist your organization, contact John Oeltjen, CPA today at (314) 862-2070 or

MPP&W, P.C. is a team of CPAs and business advisors headquartered in St. Louis. The firm offers a full range of
professional tax, audit, accounting and management advisory services, including corporate renewal services for all types
of businesses. For more details, visit www.mppw.com.

MPP&W, P.C. | 1034 S. Brentwood Blvd., Suite 1700 | St. Louis, MO 63117 | (314) 862.2070 | www.mppw.com

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