Methodology

Stocks

Module 6

What is a portfolio?

Working Capital Management

Working capital management involves the management of a company ensuring that they can meet their short-term debt obligations and expenses.

If they can’t, then it may push the company into financial difficulties.

This could have a significant impact on the company, potentially resulting in legal proceedings, strained relationships with suppliers and a loss of reputation.

Therefore, it is crucial that a company can ensure that they have enough cash available to meet their short term liabilities.

The right approach to working capital management, can help a company to improve its cash flow management and earnings quality. This is a positive thing for investors, who would benefit from the effective use of resources. 

The importance of working capital management

As stated, working capital is the difference between the money that a company earns in the short term and how much they spend/owe in the short term.

Companies aim to minimise the amount of money that they invest in working capital, in order to achieve efficiency.

If a company allocates too much money towards working capital with a lot of it not being used, then it is thought that this money has done nothing to benefit the shareholders.

Instead, shareholders would feel that the money should have been used on new projects that would increase the value of the company.

Therefore, striking the right balance is important to ensure that money is used efficiently. This balance will be different depending on the industry that a company operates in.

Measuring working capital management

The current ratio is a key ratio that measures how well a company can meet its short-term obligations. 

The current ratio is calculated using the following formula: current assets ÷ current liabilities (For example, $100m ÷ $50m = 2).

A current ratio between 1.5 and 3 is considered to be desirable.

If a company has a current ratio of 1.5, then it would essentially mean that it could meet 150% of their short term expenses or debt obligations.

So, if a company had short term expenses or debt obligations of $1m, then they would have $1.5m in cash to meet those costs.

The quick ratio is another method to measure working capital management.

The only difference is that it removes inventory from the current assets figure. This is the case because it is often uncertain how quickly a business can sell their own products.

The formula is: (current assets – inventory) ÷ current liabilities.

For example, if a company had $1m in current assets, $250k in inventory and $400k in current liabilities, it would calculate as: ($1m – $250k) ÷ $400k = 1.875.

A quick ratio between 1 and 2.5 is considered to be desirable. 

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