Working capital is defined as current assets minus current liabilities. A positive position means that a company is able to support its day-to-day operations—i.e., to serve both maturing short-term debt and upcoming operational expenses.
One of the metric’s shortcomings, however, is that current assets often cannot be liquidated in the short term. High working capital positions often indicate that there is too much money tied up in accounts receivable and inventory, rather than short-term liquidity.
All companies should therefore focus on the tight management of working capital. Inventory, accounts receivable, and accounts payable are of specific importance since they can be influenced most directly by operational management.
Companies that improve their working capital management are able to free up cash and thus can, for example, reduce their dependence on outside funding, or finance additional growth projects.
If done right, working capital management generates cash for growth together with streamlined processes along the value chain and lower costs.
Many companies still underestimate the importance of working capital management as a lever for freeing up cash from inventory, accounts receivable, and accounts payable. By effectively managing these components, companies can sharply reduce their dependence on outside funding and can use the released cash for further investments or acquisitions. This will not only lead to more financial flexibility, but also create value and have a strong impact on a company’s enterprise value by reducing capital employed and thus increasing asset productivity.
High working capital ratios often mean that too much money is tied up in receivables and inventories. Typically, the knee-jerk reaction to this problem is to apply the “big squeeze” by aggressively collecting receivables, ruthlessly delaying payments to suppliers and cutting inventories across the board. But that only attacks the symptoms of working capital issues, not the root causes. A more effective approach is to fundamentally rethink and streamline key processes across the value chain. This will not only free up cash but lead to significant cost reductions at the same time.
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