Why working capital is important as a financial KPI
Working capital is important because it represents the funds a company uses in its day-to-day trading operations. It is a measure of a company’s short-term financial health, efficiency and its ability to cover its current liabilities with its current assets. Managing working capital effectively is crucial for a business to operate smoothly and sustainably.
For example, let’s consider a retail store. The store needs to buy inventory to sell to customers, and it may offer credit terms to some of its customers, meaning it might not receive payment immediately. At the same time, the store must pay its suppliers for the goods it purchases. The working capital in this scenario would be the funds needed to purchase inventory, cover operating expenses, and manage the timing of payments from customers and to suppliers. If the store doesn’t have enough cash or short term assets, it may struggle to pay suppliers on time or replenish its inventory, potentially leading to stock outs and lost sales, therefore it is important the store can manage working capital.
Conversely, if the store has excessive working capital tied up in inventory and receivables, it might miss out on investment opportunities or struggle to meet other financial obligations, therefor it need monitoring to ensure that a company can maintain smooth operations and avoid liquidity crises.
Also related capital metrics such as days sales outstanding (DSO), days inventory outstanding (DIO), and days payable outstanding (DPO) helps identify areas for improvement in the business and optimize cash flow.
Working capital can also help identify financial risks and managing these appropriately. Monitoring changes in working capital trends can help identify potential financial risks and challenges early on. For example, a sudden increase in accounts receivable or a decrease in inventory turnover may indicate deteriorating customer credit quality or declining sales. By proactively addressing these issues, companies can mitigate risks and protect their financial stability.
Investors and creditors will also be interested in a healthy level of working capital, as it signals to investors that a company is well-managed, financially sound, and capable of meeting its short-term obligations. Conversely, poor working capital management may raise concerns about a company’s ability to weather economic downturns or unexpected challenges.
What is working capital and its components
Working capital in the financial or accounting sense is referred to the difference between the current assets of a company minus the current liabilities. Working capital are the assets and financial resource the business uses to conduct its day-to-day operations, thus being an important financial KPI for any business.
If working capital is positive it means that the business can cover its short term liabilities and convert its inventory and short term assets to cash in time to keep the business going.
Remember, current assets are assets that can be converted to cash within 1 year. Some of these can include accounts receivables, cash, short term investments and inventory.
Short term liabilities are liabilities which are expected to be settled within 1 year. Some examples of these can be accounts payable, short term loans, payroll and other bills and liabilities needed to be settled within a short time frame.
Manage working capital, what to do?
There are many ways businesses may choose to optimize and manage their working capital. Actions may include improve Accounts Receivable Management, Optimize Inventory Management, streamline inventory levels with the use of tools like JIT, negotiate better supplier terms and manage accounts payables taking advantage of longer payment terms while maintaining good business relationships.
Reduce Operating Expenses can also deliver benefits by identifying opportunities to reduce operating expenses and overhead costs without compromising quality or service levels. Implement cost-saving initiatives such as energy efficiency measures, waste reduction programs, and process optimization.
In summary, working capital management is crucial KPI for a company to manage as it maintains operational efficiency and financial stability. It helps ensure that a business can meet its short-term obligations while also taking advantage of growth opportunities.
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