Working Capital Management Guide: The Importance of Working Capital & More [Easy Calculation]
If you’ve found yourself on this blog, chances are you’re probably trying to figure out how to better manage your working capital in order to run your business more smoothly. You’re likely trying to figure out how managing working capital will help you have sufficient cash flow in your business. As entrepreneurs and small business owners ourselves, we’ve been where you are, and understand just how key working capital management is to running a successful business. In this guide, we cover the importance of working capital, how to determine working capital, and what is a good working capital ratio. On top of that, we explore various ways you can improve working capital management within your business.
What Is Working Capital Management?
Working capital management refers to the process of managing your current assets and liabilities in order to ensure efficient and effective use of your working capital. The goal of effective management of working capital is to strike a balance between maintaining adequate liquidity to meet short-term obligations and maximizing the profitability and efficiency of your business. It involves monitoring and controlling various components of working capital, including cash, accounts receivable, inventory, and accounts payable. Knowing your financial goals for your company, while keeping in mind ongoing feedback loops of information about where assets and liabilities stand, can help guide your decision-making. Knowing how those decisions affect progress toward goals is also a key aspect of the importance of working capital management.
Working capital is the difference between your company’s current assets—cash, inventory, accounts receivables—and its current liabilities—short-term loans, accrued liabilities, and accounts payables. It must be monitored to ensure a positive cash flow, and when handled correctly, it can ensure your company stays healthy and sets you up for growth. In practice, it deals with the cash conversion cycle – or, how long it takes to turn inventory into sales, receive payment, and pay vendors.
In simple terms, your company’s working capital is made up of its current assets minus its current liabilities. Just why is working capital important? There are a few reasons.
The Importance of Working Capital Management
Efficient working capital management is much more than business jargon. Overall, the importance of working capital management is that it helps maintain the financial health and sustainability of your business, and how others view your business. It also helps with:
- Fueling business growth. When capital is used wisely it can be a catalyst towards growing the business and taking on new opportunities, without the need for long-term debt.
- Making the business look appealing to potential partners, investors, and lenders. Proper management of working capital presents your business as a well-managed company instead of a risk.
- Providing funds to reinvest in your business. Positive working capital is about more than keeping sufficient cash flow on hand and having a financially solvent company. It’s also about your cash position, cash flow management, and how you’re using that money and especially how you’re capitalizing on your assets.
- Reducing stress as a business owner. Our clients have told us how stressful it is when they don’t have cash flow, which can happen even with strong working capital management due to long invoice payment terms.
Ultimately, the importance of working capital is that it helps ensure your business can keep operating, and that its resources are being used wisely. Additionally, it also helps to ensure your business is set up for future growth opportunities and expansion.
What Are the 5 Elements of Working Capital Management?
Working capital management traditionally consists of several key components that can determine your business’ financial health. At the heart of working capital management is managing these different components and looking at how they affect each other within your business.
1. Accounts receivable
Accounts receivable, also known as A/R, shows the funds your business is expecting but hasn’t received in the form of payments from customers. This could be because they aren’t due yet or your customer struggles with late payments. As such, your accounts receivables include any outstanding invoices you’ve sent to clients or customers that they’ve agreed to pay but haven’t gotten around to yet. Keep in mind that A/R is not cash. You can actually have significant amounts of A/R but no cash flow, putting you in a bind.
One solution to this problem is invoice factoring, which use invoices as collateral so that your company can get capital without creating more debt to cover any potential cash crunch. It’s a helpful option to have as a quick source of cash because not every business can meet the credit terms necessary to qualify for traditional business financing.
When calculating working capital, it’s crucial to have a clear picture of your cash situation. You can get this information by running a report like a cash flow statement, which will let you know where your business stands today and if you have adequate cash flow. A cash flow forecast lets you predict future cash flows, including shortfalls, so you can do something to prevent them — such as quickly getting an invoice funded.
3. Accounts payable
Your accounts payable (A/P) are the opposite of your accounts receivable. These are any bills your company needs to pay. Some companies delay payments as long as they can (within reason) so they can maximize the amount of available positive cash flow on their balance sheet. Others choose to pay early in hopes of capturing an early payment discount. Because the cash outflows of A/P are considered a liability, it reduces your working capital total.
It’s not uncommon for companies to see net-30, net-60, or even longer payment terms from customers. Net terms can be beneficial for large companies in the short term. However, they can also create a ripple effect throughout small and medium-sized businesses (SMBs) that are put in a tough position because their own cash flow generation is hindered as a result of slow payment. As a result, many smaller organizations may turn to short-term financing for vendor payments or inventory management during cash flow gaps.
4. Assets and inventory
Inventory your company currently has on hand is considered a positive asset. This is assuming that any inventory you have will be sold and converted into capital during the cash conversion cycle. How you manage your company’s inventory can be a strong indicator of the overall operational efficiency and financial management of your business. It’s crucial that your company maintains an optimal level of inventory: enough on hand to fulfill any orders, but not so much that the amount of working capital tied up in your inventory (or its storage) impacts your cash situation.
Business debt is considered a liability on your balance sheet, ultimately reducing your working capital. This is why managing long- and short-term debt obligations is crucial to ensuring the benefits of having the extra working capital aren’t lost to the drag of debt payments.
How business owners handle these five vital components determines how well (or how poorly) they manage their working capital.
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How Is Working Capital Management Calculated
Working capital is calculated by taking your current assets divided by your current liabilities. Generally, a current ratio above 1 means your current assets exceed your current liabilities. The higher the ratio, the better.
The calculation looks like this:
Working Capital = Current Assets / Current Liabilities
This formula gives you an idea of the availability of your short-term liquid assets after your short-term liabilities have been paid off. It is a measure of your company’s short-term liquidity and is important for keeping a constant pulse on your working capital.
What is net operating working capital?
Net operating working capital (NOWC) is a financial metric that represents the difference between your operating current assets and your operating current liabilities. It is a measure of the net investment your business has in its working capital that is required to support day-to-day operations.
To calculate NOWC, you subtract the non-interest-bearing current liabilities from the non-interest-bearing current assets. The calculation looks like this:
NOWC = Operating Current Assets – Operating Current Liabilities
Operating current assets typically include cash, accounts receivable, and inventory, which are directly related to the company’s core operations. Operating current liabilities usually include accounts payable and other short-term liabilities that arise in the course of your business operations.
NOWC is considered a more refined measure than traditional working capital, as it excludes cash and debt components that may not directly impact the operations of your business. It focuses on the net investment required in current assets to support the ongoing operations of your business.
Understanding Your Working Capital Ratio
Your working capital ratio (current ratio) is a key metric in establishing your company’s financial health. Here’s what different results mean:
- A ratio of less than 1: Your company might be unable to meet its short-term responsibilities and debt obligations, and might be dealing with liquidity issues later on. This is also a sign of a business experiencing cash flow gaps and limited cash resources. It’s possible that the business may be struggling with negative working capital, and needs to revamp its cash management strategy.
- A ratio of 2 or more: On the other hand, if your working capital ratio is too high, it might mean you have untapped potential to take advantage of growth opportunities. Suppose your current ratio is higher than 2. In that case, it may reflect that you have the excess cash and capacity to take on big projects or otherwise reinvest into the business and continue to grow your company while increasing revenue.
- A ratio of 1.5 and 2: A good working capital ratio falls between 1.5 and 2. It tells people that your business is financially solvent with plenty of cash on hand, but is still taking proactive steps to positive cash management as it pursues future business growth.
More Types of Working Capital Management Ratios
To stay on top of things, there are 5 more ratios you need to know:
Inventory turnover ratio:
How to calculate: Divide the cost of goods sold (COGS) for a certain time period by the average inventory costs for that same period.
Why it matters: Because inventory levels and supply chains can fluctuate over the course of a year, inventory management and knowing your inventory turnover ratio can give you a better grasp on if you’re moving inventory or not moving inventory, which can cause cash flow issues.
How to calculate: Multiply the number of days in a given accounting period by the average outstanding balance of accounts receivable. Then, divide by the total number of net credit sales for the same period.
Why it matters: The result of the collection ratio calculation gives you a clear understanding of how efficiently your business handles your accounts receivables and how many days, on average, it takes to receive payment after invoicing.
Quick ratio (acid-test ratio):
How to calculate: The quick ratio is calculated by dividing quick assets (current assets minus inventory) by current liabilities.
Why it matters: The quick ratio is a more stringent measure of liquidity than the current ratio. It excludes inventory from current assets since inventory may not be easily converted to cash in the short term. A higher quick ratio indicates a stronger ability to cover short-term obligations without relying on inventory sales.
Accounts receivable turnover ratio:
How to calculate: The accounts receivable turnover ratio is calculated by dividing your annual net credit sales by your average accounts receivable.
Why it matters: You can use the accounts receivable turnover ratio to determine either the days to collect accounts receivable or the number of times receivables are collected in a year. It helps you determine how frequently your company collects its accounts receivable within a specific period, typically a year.
Accounts payable turnover ratio:
How to calculate: The accounts payable turnover ratio is calculated by dividing your net credit purchases from suppliers for the period by the average accounts payable balance.
Why it matters: Tracking accounts payable turnover provides insights into your company’s efficiency in managing vendor payments and taking advantage of early payment discounts. A high accounts payable turnover ratio indicates that your company is effectively meeting its obligations to vendors and managing payables in a timely manner.
Ways to Improve Working Capital Management
Having a working capital management strategy is crucial for optimizing a company’s financial health and operational efficiency. Here are some strategies and practices that can help improve working capital management:
- Keeping a close pulse on your financials. Develop and regularly update cash flow forecasting to anticipate cash inflows and outflows accurately. This enables better planning and allocation of resources. Review and analyze working capital metrics monthly to identify trends, potential issues, and improvement opportunities.
- Working closely with a financial professional. Working with a bookkeeper, accountant, CPA, or CFO can help you have a better sense of where your financial statements are at, as well as opportunities for capital improvement. If budget is a concern, you can make use of a fractional CFO for affordability.
- Lining up multiple sources of funding. Traditional business financing from banks is notoriously difficult to qualify for, even once you get past the lengthy application process. In case the bank says no to your funding request, it can be a smart idea to have alternative funding options in your mix. Even if you already have bank financing, having a backup plan is helpful if the bank denies raising your limit on a line of credit.
- Invoice factoring. Invoice factoring is a type of revenue-based financing where you sell your outstanding invoices to a factoring company for a cash advance. The factoring company then works with your customer to settle the invoice according to the original payment terms. It’s a fast, flexible option for B2B businesses who have long invoice terms and want to tap into non-dilutive capital they’ve already earned to make payroll or fund big projects that will help them grow their business.Additionally, invoice factoring:
- Helps streamline A/R and unlocks access to cash tied up in unpaid invoices
- Puts cash in the bank, adding assets to your balance sheet. You can then use the cash to settle any A/P, removing liability from your balance sheet and increasing working capital.
- Avoids short-term debt so you aren’t reducing your working capital or adding monthly payments to your cash flow statement for unexpected costs or growth
- Helps streamline A/R and unlocks access to cash tied up in unpaid invoices
Factors That Affect Working Capital Needs
There are dozens of factors that affect an organization’s working capital requirement. Not all factors relate to all businesses, and the capital levels you need at any given time depends on your specific business model.
- The nature of the business — Do you manufacture something and sell to wholesale suppliers? If your business has a lot of overhead in the form of materials, equipment, or labor, you’ll need more working capital to meet the demands of customers. Are you a business that has naturally has long payment terms like staffing or oil & gas? You’re probably sitting on a bunch or A/R but need to cover payroll on a regular basis. What you do impacts access to capital.
- The stage of your business — If you own a small- or medium-sized business that is growing, you’ll need more working capital than if you were just trying to maintain your business.
- Seasonal or cyclical business — Are there times when you’re doing booming business and times when there is little work? When you’re busy, you need the working capital to get the job done. When you’re not, you might need it to get through the slower months.
- Operating efficiency — What is the turnaround time from production to availability of product? The length of your sales cycle? Long turnaround times require regular working capital to sustain the business.
- Availability of materials or labor — If your business depends on specific materials or specialized labor which have limited availability, you may need more working capital investment to pay for them.
- Potential for growth — If you just won a large contract and need to boost production to meet the job requirements, you may need more working capital. This can be especially true if you have a lot of bad debt or can’t meet the credit terms for a loan or line of credit from a bank or other financial institution.
- Inflation — Inflation has raised prices for almost everything, which means you need working capital to pay your costs.
In conclusion, smart working capital management is important in both meeting short-term financial obligations and strategizing for long-term growth, especially when dealing with potential financial distress. By carefully monitoring cash inflows, you can ensure you’re not only solvent today, but also in a good position for future expansion and investment opportunities. It’s about more than just numbers; it’s a holistic business strategy that determines your company’s financial health and future prospects.
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