Working Capital Management: How It Works and Why It’s Important

We define a firm’s working capital as its current assets, including cash and other assets that can be converted into cash within a year, minus its current liabilities such as accounts payable.

In this article, we discuss what working capital management is, and why it’s important for a company’s financial health.

KEY TAKEAWAYS

• Working capital management involves the administration of current assets and current liabilities.
• Working capital includes the cash that is needed to run the firm on a day-to-day basis.
• There are some factors that affect working capital requirements. These are uncertainty, credit policy, seasonality, inflation, growth rate, and cash conversion period.

Why is Working Capital Important?

Working capital is used to fund operations and meet short-term obligations. In an ideal  economy, short-term assets can always be financed with short-term debt, and long-term assets can be financed with long-term debt and equity.If a company has enough working capital, it can continue to meet its obligations, such as interest payments and taxes.

Working capital management can improve a firm’s cash flow management. If a firm has enough cash and other current assets to cover its short-term obligations like short-term debt, we can say that it has positive working capital.

In contrast, if it doesn’t have enough current assets to cover its short-term financial obligations, that means it has negative working capital – it may have difficulty paying debt and raising funds to operate its business.

The Bottom Line

Working capital management is a financial strategy that involves optimizing the use of working capital to meet operating expenses. It is important to manage working capital to drive a business and ensure it invests its resources in productive ways.

SEE ALSO: What is Financial Planning? An Overview of Financial Planning