Working Capital Management: What It Is & Why It’s Important
The management of working capital is one of the strongest indicators regarding the health of a company. Working capital, in a nutshell, is the difference between your firm’s available assets and its liabilities and includes cash, unpaid invoices, existing inventory, current accounts payables, and liabilities. That seems simple enough. But how do each of these different elements come together to form the basis of working capital management?
Key Takeaways of Working Capital Management
Working capital management traditionally consists of three key components that can determine your business’ financial health.
1. Accounts Receivable
This is all of the money currently owed to your company for any services or goods you’ve already provided and that you are expecting payment for. That means your accounts receivables also include any outstanding invoices you’ve sent to clients or customers that they’ve agreed to pay but haven’t gotten around to yet.
What’s most important about your accounts receivables is that they show whether or not you have sufficient cash flow to meet your debt obligations. These invoices can be used as collateral so that your company can borrow money to cover any potential cash flow gaps. Knowing you have incoming cash flow on the books can prove a deciding factor when applying for funding, like a loan or line of credit from a bank.
However, not all company’s can meet the credit terms necessary to qualify for a loan. Cash flow improvements and debt management also come into play for improved liquidity if your business is seen as a financial risk.
That’s when factoring your invoices with FundThrough just makes good business sense.
2. Accounts Payable
Your accounts payable are the opposite of your accounts receivable. These are any bills or other funds that your company is required to pay in the short term. Some companies delay payments as long as they can (within reason) so they can maximize the amount of available positive cash flow.
It’s not uncommon for companies to see net-30, net-60, and longer payment terms. 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 cash flow is hindered as a result of slow payment.
3. 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. How you manage your company’s inventory can be a strong indicator of the overall operational efficiency of your business. It’s crucial that your company has enough inventory on hand to fulfill any orders, but not so much that you have an inordinate amount of working capital tied up in your inventory.
How your business handles these three vital components determines how well (or how poorly) you manage your working capital. Now that you know what working capital management is, it’s imperative to understand why it’s so important.
How Is Working Capital Management Calculated
Working capital is calculated by taking your current assets divided by your current liabilities. Generally, a 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 managing cash flow and positive working capital.
Why Working Capital Management is Important for Your Business
Working capital management is much more than business jargon. Working capital management is essential to the success of your business and how your business is viewed by others. In other words, are you a well-managed company or a bankruptcy risk?
The ability to properly manage working capital directly correlates to the growth of your business, not to mention its overall operational viability. Positive working capital is about more than keeping cash on hand and having a financially solvent company. It’s about how you’re using that money and if you have the business acumen necessary to capitalize on your assets.
Sound working capital management means ensuring that your business maintains adequate cash flow, which needs to satisfy any and all operational activities and costs for the short term, in addition to any bills or other obligations. That’s on top of using your capital to maximize profits and continue to grow as a company.
Understanding Your Working Capital Ratio
The amount of working capital you have compared to your existing obligations or debts makes up your working capital ratio. The formula for your working capital ratio: take your existing assets and divide them by any liabilities you might have.
This ratio is a key metric in establishing the financial health of your company. A ratio of less than 1 may indicate that your company is unable to meet its short-term debts 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.
On the other hand, if your working capital ratio is too high, it might mean you don’t know how to take advantage of growth opportunities. If your working capital ratio is higher than 2, it may reflect that you don’t know how to make the best use of your assets to invest them back into the business and continue to grow your company while increasing revenue.
The “goldilocks” zone is generally where you want your working capital ratio to be. This tends to fall between 1.5 and 2.0. 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 growth.
Types of Working Capital Management Ratios
To stay on top of things, there are three ratios you need to know:
Working Capital Ratio: This is calculated by taking your current assets and dividing them by your current liabilities. It is probably the best indicator of your company’s financial health, debt load, and liquidity. It also reveals if you can, or can’t, meet all of your short-term debt obligations.
Inventory Turnover Ratio: You calculate this ratio by dividing the cost of goods sold (COGS) for a certain time period by the average inventory costs for that same period. Because inventories 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.
Collection Ratio: Calculate your collection ratio this way. Take ‘the number of days in an accounting period’ multiplied by ‘the average amount of outstanding accounts receivables.’ Then divide that by ‘the total amount of net credit sales during that accounting period.’ The answer gives you a clear understanding of how efficiently your business is handling your accounts receivables and how many days, on average, it’s taking to receive payment after invoicing.
How to Turn Accounts Receivable Into Working Capital
Properly managing your working capital is important for your business. But what can SMBs do to create more working capital in a world where it seems like all your customers are trying to delay payments for as long as possible?
Existing invoices are a key component of your accounts receivables. They can be used as a form of collateral in securing additional working capital for your business and for cash flow forecasting. But it can often be difficult to collect on slow-paying invoices. That’s when you need a partner, like FundThrough that can provide business funding and sufficient liquidity fast, no matter the type of industry.
This is where invoice financing and invoice factoring come in.
Invoice Financing Creates Working Capital from Existing Invoices
While extended net terms can be convenient for large businesses looking to manage their working capital, they can quickly become unfair to the small and medium-sized businesses relying on these payments to keep their businesses afloat.
Invoice factoring provides a much-needed lifeline for SMBs that want to get a firm grasp on their working capital. Alternative lending is gaining traction among small businesses thanks to its more relaxed qualifications, convenience, and fast access to capital. When SMBs are able to have up to 100 percent of their outstanding invoices advanced to them in as little as 24 hours, it’s not hard to see why.
Securing the Capital Your Business is Owed
It’s hard to talk about working capital management without having the cash flow to manage. Thanks to alternative lending services such as online invoice factoring, businesses no longer find themselves tied to one-sided net payment terms that benefit large companies.
Through access to more working capital on a faster timeline thanks to invoice factoring and invoice financing, SMBs are able to proactively manage this capital to grow their business.
Rather than wait for months to be paid for services rendered or goods produced, a business can receive the money it’s owed on time and focus on running their business, rather than tracking down customers for payment.
Factors That Affect Working Capital Needs
There are dozens of factors that affect working capital. Not all factors relate to all businesses, and how much capital you need at any given time depends on your business.
- The nature of the business — Do you manufacture something and sell to wholesale suppliers, are you a service business, or in the retail industry? What you do impacts working capital.
- The scale of your business — Are you a large or small business? Small and medium-sized businesses in all types of industries often need more working capital to fund growth.
- Credit vs. cash — Do you carry supplier invoices on the books or do you only accept cash for payment? If you’re a cash-only business, your working capital needs typically aren’t as great.
- Seasonal or cyclical business — Are there times when you’re doing a booming busy and times when there is little work? When you’re busy, you need the working capital to get the job done.
- Operating efficiency — What is the turnaround time from production to sales? Long turnaround times depend on working capital.
- Availability of materials — if your business depends on specific materials which have limited availability from suppliers, you may need more working capital to get by.
- Potential for growth — if you just won a large contract and need to boost production to meet the requirements of the job, you may need more working capital. This can be especially true if you have a lot of debt or can’t meet the credit terms for a loan or line of credit from a bank or other financial institution.
- Inflation — Inflation can mean a rise in prices, which means you need working capital to pay the higher price of goods and materials.
What Are The Benefits Of Working Capital Management
Running a business can be a major challenge. Managing working capital — and good working capital management — can help you maintain a balance and have a direct impact on profitability, liquidity, and growth.
Efficient working capital management helps ensure your business runs smoothly and includes management of your inventory, accounts receivables, and accounts payables.
It also takes maintaining both your short-term assets and liabilities to ensure you have the liquid assets necessary to run your daily operations. That’s because liquidity, or the liquid assets you can easily convert to cash, is typically tight in most small businesses. Many companies cannot find the time between delivering a product or service and being paid.
A firm grasp on working capital management then becomes imperative if you want to keep the lights on, make capital improvements, as well as have sufficient cash flow.
Make Working Capital Management Work for You
Working capital management is a feature of every well-run company. Most importantly, a business must manage working capital and have access to it on demand. FundThrough offers two capital management solutions—invoice financing and factoring—for small and medium-sized businesses. It is your financing option toward long-term financial health and cash flow management.
Are you prepared to unleash your working capital? Learn more about how invoice financing and factoring can give your business the working capital you need to succeed, even in times of economic uncertainty.
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